COSO - Internal Control Over External Financial Reporting

Co m m it te e o f S p o n s o r in g O rgani z ati o ns o f the Tre adway Co mmi ssi o n
C o m m i t t e e o f S p o n s o r i n g O r g a n i z a t i o n s o f t h e T r e a d w a y C o m m i s s i o n
Inter n al Co n t ro l — I n te g rate d F ra mewo rk
Draft for Discussion

Internal Control over External Financial Reporting:
A Compendium of Approaches and Examples
September 2012
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Inter n al Co n t ro l — I n te g rate d F ra mewo rk
Internal Control over External Financial Reporting:

A Compendium of Approaches and Examples

September 2012
Co m m it te e o f S p o n s o r in g O rgani z ati o ns o f the Tre adway Co mmi ssi o n
November 16, 2012.
responses by fax.
Committee of Sponsoring Organizations of
the Treadway Commission
Board Members Representative
COSO Chair David L. Landsittel
American Accounting Association Mark S. Beasley

Douglas F. Prawitt
The Institute of Internal Auditors Richard F. Chambers
American Institute of Certified Public Accountants Charles E. Landes
Financial Executives International Marie N. Hollein
Institute of Management Accountants Sandra Rictermeyer

Jeffrey C. Thomson

PwC
Author
Principal Contributors
Miles E.A. Everson Engagement Leader New York, USA
Stephen E. Soske Project Lead Partner Boston, USA
J. Aaron Garcia Project Lead Director San Diego, USA
Cara M. Beston Partner San Jose, USA
Charles E. Harris Partner Florham Park, USA
Eric M. Bloesch Managing Director Philadelphia, USA
James M. Downs Director San Francisco, USA

(Through January 2012)
Frank J. Martens Director Vancouver, Canada
Jay A. Posklensky Director Florham Park, USA
Charles J. Finn Senior Manager Detroit, USA
Natalie Protze Senior Manager Washington D.C., USA

(July 2011 to March 2012)
Advisory Council
Sponsoring Organizations Representatives
Audrey A. Gramling Bellarmine University Fr. Raymond J. Treece

Endowed Chair
Steven E. Jameson Community Trust Bank xecutive Vice President and
E
Chief Internal Audit & Risk
Officer
J. Stephen McNally Campbell Soup Company Finance Director/Controller
Ray Purcell Pfizer Director of Financial Controls
Bill Schneider AT&T Director of Accounting
Members at Large

Jennifer Burns Deloitte Partner
Jim DeLoach Protiviti Managing Director
Trent Gazzaway Grant Thornton Partner
Cees Klumper The Global Fund to Fight AIDS, Chief Risk Officer
Tuberculosis and Malaria
Thomas Montminy PwC Partner
Al Paulus E&Y Partner
Thomas Ray KPMG Partner
Dr. Larry E. Rittenberg University of Wisconsin Emeritus Professor of
Accounting
Chair Emeritus COSO
Ken Vander Wal ISACA President
Regulatory Observers and Other Observers
James Dalkin Government Accountability Director in the Financial

Office Management and Assurance
Team
Harrison E. Greene, Jr. Federal Deposit Insurance Assistant Chief Accuntant
Corporation
Christian Peo Securities and Exchange Professional Accounting
Commission Fellow (Through June 2012)
Amy Steele Securities and Exchange Associate Chief Accountant
Commission (Commencing July 2012)
Vincent Tophoff International Federation Senior Technical Manager
of Accountants
Keith Wilson Public Company Accounting Deputy Chief Auditor
Oversight Board
Additional PwC Contributors
Mark Cohen Partner San Francisco, USA
Andrew Dahle Partner Chicago, USA
Junya Hakoda Partner (Retired) Tokyo, Japan
Brian Kinman Partner St. Louis, USA
Pat McNamee Partner Florham Park, USA
Jonathan Mullins Partner (Retired) Dallas, USA
Alexander Young Partner Toronto, Canada
Antoine Elachkar Managing Director Washington D.C., USA
Gary Moss Managing Director Milwaukee, USA
Catherine Jourdan Director Paris, France

Frank Maggio Director Chicago, USA
Christopher Michaelson Director Minneapolis, USA
Sallie Jo Perraglia Manager New York, USA
Tracy Walker Director Bangkok, Thailand
Qiao Pan Senior Associate New York, USA

Preface
This project was commissioned by COSO, which is dedicated to providing thought lead-
ership through the development of comprehensive frameworks and guidance on internal
control, enterprise risk management, and fraud deterrence designed to improve organi-
zational performance and oversight and to reduce the extent of fraud in organizations.
COSO is a private sector initiative, jointly sponsored and funded by:
•• American Accounting Association (AAA)
•• American Institute of Certified Public Accountants (AICPA)
•• Financial Executives International (FEI)
•• Institute of Management Accountants (IMA)
•• The Institute of Internal Auditors (IIA)

Table of Contents
Foreword............................................................................................................i
1. Introduction............................................................................................... 1
2. Control Environment................................................................................11
3. Risk Assessment.................................................................................... 45
4. Control Activities......................................................................................73
5. Information and Communication...........................................................103
6. Monitoring Activities..............................................................................131
Appendix
Examples by Topic ......................................................................................148
Internal Control — Integrated Framework • September 2012

Foreword
1 In 2013, the Committee of Sponsoring Organizations of the Treadway Commission
(COSO) released an update to its Internal Control—Integrated Framework (Framework).
The original framework, which was released in 1992, has gained broad acceptance and
is widely used around the world. It is recognized as a leading framework for designing,
implementing, and conducting internal control and for establishing requirements for
an effective system of internal control. To help users apply the Framework to internal
control over external financial reporting, COSO has released this companion publica-
tion, Internal Control over External Financial Reporting: A Compendium of Approaches
and Examples (Compendium).
2 The Framework retains the core definition of internal control and the five components of
internal control. At the same time, the Framework includes enhancements and clari-
fications that are intended to ease use and application. One of the more significant
enhancements is the formalization of fundamental concepts introduced in the original
framework as principles. These principles associated with the five components provide
clarity for users in designing and implementing systems of internal control. In turn, this

Compendium provides approaches and examples to illustrate how entities may apply
the principles set out in the Framework to a system of internal control over external
financial reporting.
3 In the twenty years since the release of the original framework, business and operating
environments have changed dramatically, becoming increasingly complex, technologi-
cally driven, and global. At the same time, stakeholders have become more engaged,
seeking greater transparency and accountability for the integrity of systems of inter-
nal control that support business decisions and governance of the organization. The
Framework and the Compendium incorporate many of these changes including:
•• Expectations for Governance Oversight—Higher regulatory and stakeholder

expectations require the board of directors to oversee internal control over exter-
nal financial reporting. Some jurisdictions require specific regulatory requirements
for expertise and independence of board members of certain types of entities.
•• Globalization of Markets and Operations—Organizations expand beyond domes-

tic markets in the pursuit of value, often entering into international markets and
executing cross-border mergers and acquisitions.
•• Changes and Greater Complexity in the Business—Organizations change busi-

ness models and enter into complex transactions in pursuit of growth, greater
quality, and productivity, and in response to changes in market and regulatory
environments. These changes may include entering into strategic alliances, joint
ventures, and other complex contractual arrangements with external parties,
implementing shared services, and engaging outsourced service providers.
Internal Control — Integrated Framework • September 2012 i

Internal Control over External Financial Reporting: A Compendium of Approaches and Examples
Control Environment • Risk Assessment • Control Activities • Information and Communication • Monitoring Activities
•• Demands and Complexities in Laws, Rules, Regulations, and Standards—Regula-

tors and policy makers promote greater investor protection and confidence in the
financial reporting systems through changes in rules, regulations, and standards.
Also, users of external financial reports seek greater amounts of information to
better evaluate an entity’s financial condition and operating results as businesses
become more complex.
•• Expectations for Competencies and Accountabilities—Demands for greater

competence and accountability increase as organizations grow; acquire entities;
introduce new products and services; comply with complex rules, regulations,
and standards; and implement new processes and technologies. Organizations
may flatten and shift management operating models and delegate greater author-
ity or accountability to certain roles.
•• Use of, and Reliance on, Evolving Technologies—An increasingly mobile and
interconnected world has made technology more essential for many organizations
to improve performance, business processes, and decision making. Entities are
investing in emerging technologies, such as cloud computing, mobile devices,
and social media, and using enterprise resource planning (ERP) and other tech-
nologies to standardize, automate, and streamline business processes.

•• Expectations Relating to Preventing and Detecting Fraud—Today there is higher
stakeholder and regulatory scrutiny over external financial reports with respect
to material misstatements and fraudulent reporting. More countries are enact-
ing fraud statutes, and regulators are targeting more entities and executives
for investigation.
4 Each of these changes requires an organization to evaluate the implications on its

system of internal control over external financial reporting and to design and implement
appropriate responses so that the system of internal control adapts and remains effec-
tive over time.
5 The Compendium illustrates how entities can apply the Framework to design, imple-
ment, and conduct internal control over external financial reporting. It neither replaces
nor modifies the Framework; rather, it is a supplemental document that can be
used in concert with the Framework when considering internal control over external
6 Finally, the COSO Board would like to thank PwC and the Advisory Council for their
contributions in developing the Compendium. Their full consideration of input provided
by many stakeholders and their attention to detail were instrumental in ensuring that the
Compendium will be helpful to a variety of organizations in applying the Framework to
internal control over external financial reporting.
ii Internal Control — Integrated Framework • September 2012

Introduction
1. Introduction
7 COSO’s Internal Control—Integrated Framework (Framework) sets forth three catego-
ries of objectives: operations, reporting, and compliance. The focus of this publication,
Internal Control over External Financial Reporting: A Compendium of Approaches and
Examples (Compendium) is the external financial reporting category of objectives, a
subset of the reporting category. External financial reporting objectives address the
preparation of financial reports for external parties, including:
•• Financial statements for external purposes, and
•• Other external financial reporting derived from an entity’s financial and accounting
books and records.
Using this Document

8 The Compendium has been developed to assist those users of the Framework who are
responsible for designing, implementing and conducting a system of internal control

over external financial reporting (ICEFR) that supports the preparation of financial state-
ments and other external financial reporting. It is also relevant to entities that report
on the effectiveness of internal control over financial reporting relating to financial
statements for external purposes. The preparation of financial statements for external
purposes and other external financial reporting applies to:
•• Public Entities—Often, public entities are required by rules and regulations

to prepare financial statements for external purposes; additionally, they often
prepare other external financial reporting derived from its financial and account-
ing books and records, such as earnings press releases, or information included
in stipulated reports for business partners or lending agencies as required by
contractual obligations.
•• Private Entities—Entities whose ownership may be closely held may prepare finan-
cial statements to provide to banks and other third parties in order to raise capital
or to meet contractual obligations. These can be in accordance with standards
and regulations, however often, there is no requirement for private entities to
prepare the financial statements in accordance with specific standards or regula-
tions; the form of the financial statements or other external financial reporting is
stipulated by contractual obligations or a third party.
•• Not-For-Profit Entities—These entities may prepare financial statements for

external purposes in accordance with appropriate rules and regulations, however
since these entities’ purpose is other than realizing and generating profit, they
may prepare other financial reporting for donors, government agencies, or other
third parties in order to raise funds to support the stated cause, not necessarily in
accordance with specific standards or regulations.
Internal Control — Integrated Framework • September 2012 1

•• Governmental Entities—In addition to any financial statements for external pur-

poses that might be required by law, governmental entities may prepare financial
reporting, to provide to the public or to other governmental oversight agencies
that is not necessarily required to be prepared in accordance with specific stan-
dards or regulations.
9 In applying the Framework, users will find relevant approaches and examples in the
Compendium of how organizations apply various aspects of the principles in the design,
implementation and conduct of internal control over external financial reporting objec-
tives. These approaches and examples relate to each of the five components and sev-
enteen principles set forth in the Framework.
•• Approaches describe how organizations may apply these principles within

their system of internal control over external financial reporting. Approaches
are designed to give users of the Compendium a summary-level description of
activities that management may consider as they apply the Framework in an
ICEFR context.
•• Examples provide specific illustrations to users on the application of each princi-

ple, based on situations drawn from practical experiences. Examples may illus-

trate one or more points of focus of a particular principle. They are not designed
to provide a comprehensive, end-to-end example of how the principle may be fully
applied in practice.
10 The Compendium includes an appendix that highlights those examples that relate to the
changes in business and operating environments that are noted in the Framework.
11 Note that this document is not designed to be read from beginning to end. Nor are the
approaches and examples linked across the principles; rather, they stand on their own
and relate to specific points of focus of the principles. Finally, even though the defini-
tions, components, principles, and points of focus are consistent with those found in the
Framework, readers should refer to the Framework for a comprehensive discussion of
how entities design, implement, and conduct internal control, and for the requirements
of an effective system of internal control.
Specific Considerations of External Financial

Reporting
12 This section considers some unique aspects of applying the Framework in the context
of external financial reporting, and especially preparing financial statements for
external purposes.
Types of External Financial Reports

13 External financial reporting objectives are consistent with accounting principles suitable
and available for that entity and appropriate in the circumstances. External financial
reporting objectives address the preparation of financial reports, including financial
statements for external purposes and other external financial reporting derived from an
entity’s financial and accounting books and records.
2 Internal Control — Integrated Framework • September 2012

Introduction
Financial Statements for External Purposes

14 Financial statements for external purposes are prepared in accordance with applicable
accounting standards, rules and regulations. These financial statements include annual
and interim financial statements, condensed financial statements, and selected finan-
cial information derived from such statements. These statements may, for instance, be
publicly filed with a regulator, distributed through annual meetings, posted to an entity’s
website, or distributed through other electronic media.
15 Another form of financial statements prepared for external purposes may be financial
reports prepared in accordance with other comprehensive basis of accounting, such as
those by taxing authorities, regulatory agencies, or requirements established through
contracts and agreements. These financial reports are typically distributed to specified
external users (e.g., reporting to a bank on financial covenants established in a loan
agreement, to a taxing authority in connection with filing tax returns, reporting on finan-
cial information to an energy regulatory commission)).
Other external financial reporting

16 Other external financial reporting derived from an entity’s financial and manage-

ment accounting books and records rather than from financial statements for external
purposes may include earnings releases, selected financial information posted to an
entity’s website, and selected amounts reported in regulatory filings. External finan-
cial reporting objectives relating to such other financial information may not be driven
directly by standard setters and regulators, but are typically expected by stakeholders
to align with such standards and regulations.
Suitable Objectives of Financial Statements for

External Purposes
Complies with Applicable Accounting Standards

17 Regulators and accounting standard-setters establish laws, rules, and standards relat-
ing to the preparation of financial statements for external purposes. These financial
reporting rules and standards form the basis upon which management specifies suit-
able objectives for the entity and its subunits.
18 When specifying suitable external reporting objectives relating to the preparation of

financial statements, management considers the accounting standards that are appli-
cable to that entity and its subunits. Management also specifies the accounting prin-
ciples that are appropriate in the circumstances. For example, management may set
an entity-level external financial reporting objective as follows: “Our Company prepares
reliable financial statements reflecting activities in accordance with generally accepted
accounting principles.”
19 Management specifies suitable sub-objectives for divisions, subsidiaries, operat-

ing units, and functions with sufficient clarity to support entity-level objectives. For
example, a US company applies accounting principles generally accepted in the United
States of America (US GAAP) to all subunits in preparing its consolidated financial
statements, and it applies International Financial Reporting Standards (IFRS) to those

subunits that submit subsidiary financial statements in statutory filings in non-United

States jurisdictions.
20 Further, management specifies appropriate accounting principles (e.g., US GAAP, IFRS)

to apply to transactions and events of the entity. For example, management speci-
fies that FASB Accounting Standard Codification No. 605 Revenue Recognition and
SAB 101A Revenue Recognition in Financial Statements (US GAAP) or IAS 18 Revenue
Recognition (IFRS) apply to all sales transactions as applicable to the entity or subunits’
respective external financial reporting objective.
Considers Materiality
21 Financial statement materiality sets the threshold for determining whether a financial
amount is relevant. Entities must consider suitable regulations and guidance promul-
gated by standard-setters and regulators.1
Reflects Entity Activities

22 External financial reporting reflects the entity’s transactions and events. In preparing
external financial statements, management implicitly or explicitly considers suitable

objectives and sub-objectives relating to qualitative characteristics (e.g. reliability, trans-
parency) and assertions (e.g., existence and completeness of transactions). Accounting
standard setters may also determine relevant qualitative characteristics and assertions
for external financial reporting.
23 For example, reliability is a frequently used qualitative characteristic associated with

external financial reporting objectives. Reliability involves preparing external financial
statements that are free of material error and bias. Reliability is also necessary for an
entity’s external reporting to faithfully represent the transactions or other events it pur-
ports to represent.
24 Management makes assertions regarding the recognition, measurement, presenta-

tion, and disclosure of account balances and classes of transactions and events in the
entity’s financial statements. For example, one grouping of assertions relating to finan-
cial statements is summarized as follows:2
•• Existence or Occurrence—Assets, liabilities, and ownership interests exist at a

specific date and recorded transactions represent events that actually occurred
during a certain period.
•• Completeness—All transactions and other events and circumstances that

occurred during a specific period, and that should have been recognized in that
period, have in fact been recorded.
•• Rights and Obligations—Assets are the rights and liabilities are the obligations of
the entity at a given date.
1 For example, Topic 1M of the Staff Accounting Bulletins of the United States Securities and Exchange
Commission provides guidance on assessing materiality.
2 These financial statement assertions are substantially consistent with those established by the American
Institute of Certified Public Accountants and the International Auditing and Assurance Standards Board.

Introduction
•• Valuation or Allocation—Asset, liability, revenue, and expense components are

recorded at appropriate amounts in conformity with relevant and appropriate
accounting principles. Transactions are mathematically correct and appropriately
summarized and recorded in the entity’s books and records.
•• Presentation and Disclosure—Items in the statements are properly described,

sorted, and classified.
25 For example, management specifies sub-objectives for sales transactions that apply
applicable accounting standards based on the circumstances and that address relevant
financial statement assertions and qualitative characteristics, such as:
•• All sales transactions that occur are recorded on a timely basis.
•• Sales transactions are recorded at correct amounts in the right accounts.
•• Sales transactions are accurately and completely summarized in the entity’s

books and records.
•• Presentation and disclosures relating to sales are properly described, sorted,

and classified.

26
Judgment
In preparing financial statements, management exercises judgment in complying with
external financial reporting requirements. Management considers how identified risks
to specified financial reporting objectives and sub-objectives should be managed.
Management’s alternatives to respond to risk may be limited compared to some other
categories of objectives. That is, management is less likely to accept a risk than to
reduce the risk. For instance, management may decide to mitigate a risk by outsourc-
ing transaction processing to a third party that is better suited to perform the business
process. However, management always retains responsibility for designing, implement-
ing, and conducting its system of internal control even when outsourcing to a third
party. For external financial reporting objectives, risk acceptance or avoidance should
occur only when identified risks could not, individually or in aggregate, exceed the risk
threshold and result in a material misstatement.
27 Management also exercises judgment in selecting and applying suitable account-

ing principles, particularly those relating to subjective measurements and complex
transactions. For instance, management exercises judgment in making assumptions
and using data in developing accounting estimates, in applying accounting principles
to complex transactions, and in preparing reliable and transparent presentations and
disclosures. Internal control over external financial reporting addresses the potential
for bias in exercising judgment that could lead to a material misstatement in external

Overlapping Objectives
28 Many controls are interrelated and may support multiple objectives. An objective in one
category may overlap or support an objective in another. For example, “closing financial
reporting period within five workdays” may be a goal supporting primarily an operations
objective—to support management in reviewing business performance. But it also sup-
ports timely reporting and timely filings with regulatory agencies.
29 The category in which an objective falls can sometimes vary depending on the circum-
stances. For instance, controls to prevent theft of assets—such as maintaining a fence
around inventory, or having a gatekeeper to verify proper authorization of requests for
movement of goods—fall under the operations category. These controls may not be
relevant to reporting where inventory losses are detected following periodic physical
inspection and recording in the financial statements. However, if for reporting pur-
poses management relies solely on perpetual inventory records, as may be the case for
interim or internal financial reporting, the physical security controls would then also fall
within the reporting category. These physical security controls, along with controls over
the perpetual inventory records, are needed to achieve reporting objectives. A clear
understanding is needed of the entity’s processes and its policies, procedures, and the

respective impact on each category of objectives.
Deficiencies in Internal Control

30 The term “internal control deficiency” refers to a shortcoming in a component or
relevant principle of the system of internal control that has the potential to adversely
affect the ability of the entity to achieve its objectives. There are many potential sources
for identifying internal control deficiencies, including the entity’s monitoring activi-
ties, assessment of effectiveness in other components of internal control, and external
parties that provide input relative to the presence and functioning of a component or
relevant principle.
31 When an organization determines that an internal control deficiency exists, management

must assess the severity of that deficiency based on its potential effect on the entity’s
system of internal control. Assessing the severity of an internal control deficiency or
combination of deficiencies requires management to exercise judgement to determine
the potential impact on the system of internal control. Regulators, standard-setting
bodies, and other relevant third parties establish criteria for evaluating the severity and
corresponding classification and reporting of deficiencies relating to external reporting,
operations, and compliance objectives. As well, for internal reporting and other opera-
tions objectives, management and board of directors may need to establish objective
criteria for evaluating internal control deficiencies and reporting to those responsible for
achieving these objectives. The Framework does not prescribe such criteria, but rec-
ognizes and accommodates the authority and responsibility of those other parties that
interact with the entity to issue such laws, rules, regulations, and standards for conduct-
ing assessments and classifications.

Introduction
32 In those instances where an entity is applying an external law, rule, regulation, or

standard, management considers terms relating to internal control deficiencies and
the unique considerations of those standards. Management also needs to develop an
understanding of any differences between those laws, rules, regulations, and standards
when applying the Framework. For instance, regulators prescribe rules for evaluating
internal control deficiencies relating to external financial reporting and define terms
describing the severity of such deficiencies, which may include material weakness and
significant deficiency3. For purposes of applying the Framework to external financial
reporting, management must apply the laws, rules, regulations and standards appropri-
ate for the entity in evaluating, classifying and reporting internal control deficiencies.
Smaller Entities
33 The seventeen principles underlying the five components of internal control are appli-
cable for entities of all sizes. However, smaller entities may apply these principles using
different approaches. For example, all public companies have boards of directors or
other similar governing bodies with oversight responsibilities relating to the entity’s
external financial reporting. A smaller entity may have a less complex business model,

organizational and legal structures, and operations and more frequent communica-
tion with directors, enabling greater reliance on board oversight for achieving effective
internal control.
34 The approaches contained within the Compendium are designed to be universal in

nature and apply to any entity type or size. The examples, however, derived from actual
situations, might include specific facts and circumstances that relate more to a larger
entity. In some situations the Compendium includes examples that are specific to
smaller entities, and there are footnotes that note when this is the case. In most cases
though, the examples would likely translate well to applications for both smaller and
larger entities.
Documentation
35 Two levels of documentation requirements should be considered in relation to financial
statements for external purposes.
•• In cases where management asserts to regulators, shareholders, or other third

parties on the design and operating effectiveness of its overall system of inter-
nal control, management has a higher degree of responsibility. Typically this will
require documentation to support the assertion that all components of internal
3 For the purposes of the Compendium, approaches and examples will reference the terms “material weak-
ness” and “significant deficiency” as defined by the Securities Exchange Commission in the United States.
“Material weakness” means a deficiency, or a combination of deficiencies, in internal control over financial
reporting (as defined in Rule 13a-15(f) or Rule 15d-15(f) of this chapter) such that there is a reasonable
possibility that a material misstatement of the registrant’s annual or interim financial statements will not be
prevented or detected on a timely basis. Rule 1–02 of Regulation S–X. “Significant deficiency” means a
deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe
than a material weakness, yet important enough to merit attention by those responsible for oversight of
the registrant’s financial reporting. Rule 1–02 of Regulation S–X.

control are in place and functioning. The nature and extent of the documentation
may be influenced by the entity’s regulatory requirements. This does not neces-
sarily mean that all documentation will or should be more formal, but that suffi-
cient evidence that the components of internal control are present and operating
together is available and suitable to satisfy the entity’s objectives.
•• In cases where an external auditor attests to the effectiveness of the overall

system of internal control, management will likely be expected to provide the
auditor with support for its assertion on the effectiveness of internal control. That
support would include evidence that the system of internal control is properly
designed and operating effectively. In considering the nature and extent of docu-
mentation needed, management should also remember that the documentation
to support the assertion will likely be used by the external auditor as part of his or
her audit evidence. Management may also document significant judgments, how
such decisions were considered, and the final decisions reached.
Approaches and Examples for Applying Principles

36 The Compendium illustrates through approaches and examples how the principles
apply to external financial reporting objectives. Each chapter focuses on one of the five
components of internal control and contains:
•• A summary of the component that is consistent with the Framework
•• A listing of principles associated with that component
•• A listing of relevant approaches for applying principles in an external financial

reporting context
37 For each principle, there is a listing of approaches that illustrate how organizations
apply the principles in designing, implementing or conducting certain aspects of internal
control over external financial reporting. The approaches apply to any size or type of
entity, and, for consistency and illustrative purposes, incorporate the points of focus
contained in the Framework. This structure is intended to assist users in understand-
ing the linkages of the points of focus to its associated principle. Various organizations
apply these approaches differently depending on the entity’s circumstances, and the
application by a particular entity is likely to evolve as circumstances change over time.
The approaches included are not intended to be a comprehensive listing. Users should
recognize that points of focus not listed in the Framework may also be suitable and
relevant in the user’s judgement depending upon the entity’s particular circumstances.
38 For each approach, one or more examples are provided to illustrate how an important
aspect of the approach has been put in place by entities that prepare financial state-
ments for external purposes. The examples are based on experiences of entities, and
some details may have been modified for the purposes of this publication (e.g., entity
and personal names are fictional and not attributable to any specific entity). The exam-
ples are not intended to be construed as “best practices” or suggested solutions for
users of the Framework. Further, the examples are not necessarily sufficient to demon-
strate that a particular principle is present and functioning as defined in the Framework.

Introduction
39 These approaches and examples are likely to be relevant to many types of entities
(including public, private, not-for-profit, and governmental entities) that aim to prepare
financial statements for external purposes and other forms of external financial report-
ing. Where an example is not applicable to all types of entities, this is noted. Finally,
even though the approaches and examples primarily relate to the preparation of finan-
cial statements for external purposes, any entity seeking to design, implement and
conduct a system of internal control to achieve other external financial reporting objec-
tives may also benefit from them.


Components of Internal Control | Control Environment
2. Control Environment
Chapter Summary
40 The control environment is the set of standards, processes, and struc-
tures that provide the basis for carrying out internal control across the
organization. The board of directors and senior management establish
the tone at the top regarding the importance of internal control includ-
ing expected standards of conduct. Management reinforces expecta-
tions at the various levels of the organization. The control environment
comprises the integrity and ethical values of the organization; the pa-
rameters enabling the board of directors to carry out its oversight re-
sponsibilities; the organizational structure and assignment of authority

and responsibility; the process for attracting, developing, and retaining
competent individuals; and, the rigor around performance measures, in-
centives, and rewards to drive accountability for performance. The re-
sulting control environment has a pervasive impact on the overall system
of internal control.
Principles relating to the Control Environment component
1. The organization demonstrates a commitment to integrity and

ethical values.
2. The board of directors demonstrates independence from

management and exercises oversight for the development and
performance of internal control.
3. Management establishes, with board oversight, structures, reporting

lines, and appropriate authorities and responsibilities in the pursuit
of objectives.
4. The organization demonstrates a commitment to attract, develop,

and retain competent individuals in alignment with the objectives.
5. The organization holds individuals accountable for their internal

control responsibilities in the pursuit of objectives.

Framework | Control Environment • Risk Assessment • Control Activities • Information and Communication • Monitoring Activities
Principles Approaches
1. The organization demonstrates •• Establishing Standards of Conduct

a commitment to integrity and
•• Leading by Example on Matters of
ethical values.
Integrity and Ethics
•• Evaluating Management and Other

Personnel, Outsourced Service
Providers, and Business Partners for
Adherence to Standards of Conduct
•• Reporting and Taking Prompt Action

on Deviations from Standards of
Conduct
2. The board of directors demonstrates •• Establishing the Roles, Responsibili-

independence from management ties, and Delegation of Authority of
and exercises oversight for the the Board of Directors
development and performance of
•• Establishing Policies and Practices

internal control.
for Meetings between the Board of
Directors and Management
•• Identifying and Reviewing Board of

Director Candidates
•• Reviewing Management’s Assertions

and Judgments
•• Obtaining an External View
•• Considering Whistle-Blower Informa-

tion about Financial Statement Errors
and Irregularities
3. Management establishes, with board •• Defining Roles and Reporting Lines

oversight, structures, reporting and Assessing Them for Relevance
lines, and appropriate authorities
•• Defining Authority at Different Levels
and responsibilities in the pursuit
of Management
of objectives.
•• Maintaining Job Descriptions and
Service-Level Agreements
•• Defining the Role of Internal Auditors

Components of Internal Control | Control Environment
4. The organization demonstrates a •• Establishing Required Knowledge,

commitment to attract, develop, Skills, and Abilities
and retain competent individuals in
•• Linking Competence Standards
alignment with the objectives.
to Established Policies and Prac-
tices in Hiring, Training, and
Retention Decisions
•• Identifying and Delivering on Financial

Reporting Related Training as Needed
•• Selecting Appropriate Outsourced

Service Providers
•• Evaluating Competence and Behavior
•• Evaluating Sufficiency and Compe-

tency of Finance Personnel
•• Developing Alternate Candidates for

Key Financial Reporting Roles
5. The organization holds individu- •• Defining and Confirming

als accountable for their internal Responsibilities
control responsibilities in the pursuit
•• Developing Balanced Performance
of objectives.
Measures, Incentives, and Rewards
•• Evaluating Performance Measures for

Intended Influence
•• Linking Compensation and Other

Rewards to Performance

Demonstrates Commitment to Integrity and

Ethical Values
Principle 1. The organization4 demonstrates a commitment
to integrity and ethical values.
Points of Focus
41 The following points of focus may assist management in determining whether this prin-
ciple is present and functioning:
•• Sets the Tone at the Top—The board of directors and management at all levels of
the organization demonstrate through their directives, actions, and behaviors the
importance of integrity and ethical values to support the functioning of the system
of internal control.
•• Establishes Standards of Conduct—The expectations of the board of directors

and senior management concerning integrity and ethical values are defined in the
entity’s standards of conduct and understood at all levels of the organization and

by outsourced service providers and business partners.
•• Evaluates Adherence to Standards of Conduct—Processes are in place to

evaluate the performance of individuals and teams against the entity’s expected
standards of conduct.
•• Addresses Deviations in a Timely Manner—Deviations of the entity’s

expected standards of conduct are identified and remedied in a timely and
consistent manner.
4 The term “organization” is used to collectively capture the board of directors, management, and other
entity personnel as reflected in the definition of internal control

Control Environment | Demonstrates Commitment to Integrity and Ethical Values
Approaches and Examples to Applying the Principle
Approach: Establishing Standards of Conduct

42 Senior management, with guidance from the board of directors, defines and commu- Sets the Tone at the Top
nicates expected standards of conduct for the organization, including any specific to • Establishes Standards of Conduct
those responsible for preparing external financial reporting. Senior management may do
Evaluates Adherence to Standards
this by: of Conduct
•• Reflecting legal, ethical, and other expectations in the conduct of business and Addresses Deviations in a Timely Manner
financial reporting
•• Articulating management’s philosophy and guidance for avoiding moral hazards in

the pursuit of objectives
•• Using established professional codes of conduct, such as those associated with

financial and managerial accounting, legal, information technology, or other pro-
fessional organizations
•• Permeating standards of conduct throughout the organization, including guide-

lines for application to high-risk issues and geographies

•• Communicating and reinforcing the accountability for responsible conduct of
all personnel
•• Setting the expectation that personnel raise issues or questions relating to the
application of the defined standards
•• Making explicit the consequences for deviations from standards of conduct at any
level in the organization
•• Ensuring that new and existing employees are trained on the entity’s standards
of conduct and continuing education, and providing appropriate briefings to third
parties engaging in business with the company
•• Developing performance evaluation processes and incentives (and service-level

agreements as necessary) that promote the right behavior in pursuit of objectives
•• Providing staff ethics training opportunities to insure that all employees have the
knowledge to identify and deal with dilemmas
Example: Defining and Communicating a Code of Business Conduct

and Ethical Standards
43 The senior management of Zanzibar Co., a publicly traded company, has created, main-
tains, and distributes the company’s code of business conduct and ethical standards to
all employees and external parties acting on behalf of the company, and has posted it
on the company website. The code of conduct is available in all relevant languages for
ease of access and understanding by all within the global organization. The company
also requires all employees to complete periodic interactive web-based training ses-
sions on various aspects of the code and ethical standards.
44 Furthermore, the company provides a supplier code of conduct to its vendors as part
of its service-level agreements, which provide a basis for evaluation alongside product/
service delivery evaluation.

45 These documents emphasize that every individual is responsible for maintaining an

ethical environment and reporting any ethical breaches. Service-level agreements and
contracts with external parties include the relevant language to specify the company’s
expected standards of conduct and serve as a basis for evaluating adherence. The
code also specifically sets the expectation of reporting and resolving issues by provid-
ing clear information on how to ask a policy question or report a violation through an
independent third party.
Approach: Leading by Example on Matters of Integrity and Ethics

• Sets the Tone at the Top 46 The CEO and key members of management articulate and demonstrate the importance
• Establishes Standards of Conduct
of integrity and ethical values across the organization. The various forms and mecha-
nisms used to do this may include:
of Conduct •• Communications from senior management that support the expected standards
Addresses Deviations in a Timely Manner of conduct and that stay consistent as they permeate throughout the organization
•• Day-to-day actions and decision making at all levels of the organization that are

consistent with the expected standards of conduct
•• Interactions with suppliers, customers, and other external parties that reflect fair
and honest dealings
•• Performance appraisals and incentives that reinforce expected standards of

behavior consistent with the entity’s objectives at all levels of the organization
•• Timely inquiries and investigations into any alleged conduct that is inconsistent
with the entity’s standards of conduct
•• Corrective action when deviations from expected standards of conduct occur
47 While this approach can be synonymous with that of establishing standards of conduct
when both operate effectively, history has shown instances where organizations define
and communicate honorable standards of conduct, yet senior management does not
internalize or exhibit these standards in its conduct, and therefore sets a different tone
than what is expected.
Example: Using a Company Newsletter to Reinforce Expectations of

Integrity and Ethics
48 Space Inc., a supplier to the aerospace industry, uses its monthly newsletter to employ-
ees, outsourced service providers, business partners, and other external parties to
emphasize the importance of exercising sound integrity and ethical values. Each edition
of the newsletter contains a section related to ethical decision making and conse-
quences of violations of the code. The newsletter draws attention to the multitude of
resources available to discuss and resolve ethical issues; it also reports what actions
are taken by senior management when the code is violated at any level of the organiza-
tion. The newsletter illustrates the open dialogue and resolution of issues that is actively
promoted by senior management.
49 Examples of ethical dilemmas are provided, along with suggested resolutions. The
newsletter points out that reports of violations originate from a variety of sources,

including employees, managers, the company’s anonymous hotline, and external

parties. Responses range from no action (in cases where the violation is shown not to
have occurred) to various levels of discipline, including dismissal.
50 Finally, the newsletter reminds all Space Inc. employees—from senior management
to all levels of employees—that as part of their annual performance review they must
certify that they have read the company’s mission statement and code of conduct and
that they comply with policies at all times.
Approach: Evaluating Management and Other Personnel, Out-

sourced Service Providers, and Business Partners for Adherence to
Standards of Conduct
51 The board of directors and senior management evaluate adherence to the company’s Sets the Tone at the Top
standards of conduct. This is accomplished in a variety of ways, which may include: Establishes Standards of Conduct
•• Assessing results from training and ethics certification processes • Evaluates Adherence to Standards
of Conduct
•• Considering anomalies in key performance indicators and internal analytical

Addresses Deviations in a Timely Manner
reviews of operational and financial information that could be a potential indicator
of fraudulent financial reporting or other misconduct
•• Considering the results from ongoing and separate evaluations of internal control,
which include evaluations of internal control at outsourced service providers and
business partners who provide information necessary to produce external finan-
cial reporting
•• Analyzing issues and trends from hotlines and help lines made available within
the organization that could indicate potential fraud occurrences and other
ethical concerns
•• Requesting feedback from meetings held with outsourced service providers and
business partners when obtaining financial information or information that impacts
the entity’s internal control over external financial reporting
Example: Conducting Ethics Audits

52 The not-for-profit organization Partners for Development conducts scheduled audits
to determine whether employees are receiving and understanding the board-approved
standards of conduct when they are first hired and as part of communications, training,
and annual review processes. The audits also include non-employees and consultants
from their IT service provider. The standards consist of three documents: the code of
ethics and standards of personal conduct, the compliance policy statement, and the
expected standards of conduct.
53 Partners for Development’s purpose in conducting these audits is to determine if there

are any instances of non-compliance and to use those findings to assess and correct
any deficiencies in the organization’s new-hire orientation, communications, training,
and employee review processes. Upholding the organization’s standards of conduct is a
fundamental requirement for continued funding from its government sponsors.

Example: Evaluating Misconduct Reported through an

Anonymous Hotline
54 All-World Food Distributors provides an anonymous hotline for employees to report
potential fraud and other ethical concerns. The entity engages a third-party service
provider to administer the hotline to provide the comfort of anonymity for its employees.
This service immediately reports any potentially illegal acts or financial reporting impro-
prieties directly to the company’s legal department and audit committee. Issues and
trends are analyzed and conclusions are reported to the audit committee of the board.
Approach: Reporting and Taking Prompt Action on Deviations from

Standards of Conduct
Sets the Tone at the Top 55 Senior management develops and consistently follows a prescribed process and
Establishes Standards of Conduct standard to promptly investigate, report, and take action to correct any violations to the
standards of conduct occurring at any level of the organization, including outsourced
of Conduct service providers and business partners. The process may include:

• Addresses Deviations in a Timely Manner •• Having individuals who are independent of the alleged matter conducting
the investigation
•• Investigating occurrences of possible violations to ensure a thorough understand-

ing of issues and circumstances
•• When applicable, assessing the financial statement impact and determining

what internal controls over external financial reporting may have failed to detect
the matter
•• Developing appropriate support documentation and reporting
•• Identifying and communicating with anyone under investigation (or after thorough
investigation in instances of alleged fraud), and following up on any corrective
actions taken to remedy the matter in a consistent and timely basis and according
to prescribed company guidelines
•• Communicating to all company personnel that appropriate investigation and cor-

rective actions have been taken
•• Depending on the nature and pervasiveness of the deviation that has occurred,
establishing remediation activities as needed to make retrospective correc-
tions and forward-looking improvements (Remediation may address account-
ing corrections needed, process control enhancements, systems development
or enhancements, accountability reinforcement, training, and other actions.
The board reviews and approves the adequacy of remediation measures and
progress reports.)

Example: Taking Action when Deviations Occur

56 Best Fit Shoes has established policies and procedures to address serious impropri-
eties or illegal acts by employees, such as theft or bribing a new supplier to secure a
contract. The policy empowers the legal department to initiate the investigation together
with the internal audit department or an external third party in order to understand,
document, and report the facts of the alleged matter for evaluation and assessment.
57 Best Fit’s policy clearly states that if such an illegal act or impropriety is confirmed,
the company will terminate the employee, revoke all access privileges, and file formal
charges with appropriate authorities. The policy also requires the human resources
manager to document the situation and its resolution, analyze the root cause of the
breach, and implement any additional remedial steps to avoid similar occurrences in the
future. Progress reports are regularly provided to the audit committee.
58 During one instance, facilitation payments were made to obtain certain contracts, the
policy was immediately applied, an investigation was launched; the audit committee
was notified and regularly presented with progress updates and the proposed correc-
tive actions for approval.

Exercises Oversight Responsibility

Principle 2. The board of directors demonstrates
independence from management and exercises oversight
for the development and performance of internal control.
Points of Focus
ciple is present and functioning.
•• Establishes Oversight Responsibilities—The board of directors identifies and

accepts its oversight responsibilities in relation to established requirements
and expectations.
•• Applies Relevant Expertise—The board of directors defines, maintains, and

periodically evaluates the skills and expertise needed among its members
to enable them to ask probing questions of senior management and take
commensurate actions.

•• Operates Independently—The board of directors has sufficient members who are
independent from management and objective in evaluations and decision-making.
•• Provides Oversight for the System of Internal Control—The board of directors

retains oversight responsibility for management’s development and performance
of internal control:
-- Control Environment—Establishing integrity and ethical values, oversight

structures, authority and responsibility, expectations of competence, and
accountability to the board
-- Risk Assessment—Overseeing management’s assessment of risks to the

achievement of objectives, including the potential impact of significant
changes, fraud, and management override of internal control
-- Control Activities—Providing oversight to senior management in the develop-

ment and performance of control activities
-- Information and Communication—Analyzing and discussing information relat-

ing to the entity’s achievement of objectives
-- Monitoring Activities—Assessing and overseeing the nature and scope

of monitoring activities and management’s evaluation and remediation
of deficiencies

Control Environment | Exercises Oversight Responsibility
Approach: Establishing the Roles, Responsibilities, and Delegation

of Authority of the Board of Directors5
60 The roles, responsibilities, and powers of delegation of the board of directors are • Establishes Oversight Responsibility
defined in its corporate bylaws and committee charters in accordance with applicable Applies Relevant Expertise
regulatory and listing requirements. For external financial reporting purposes, the board • Operates Independently
typically forms an audit committee whose responsibilities include overseeing:
• Provides Oversight for the System of
•• The effectiveness of internal control over external financial reporting, including the Internal Control
assessment of risks, significant deficiencies, and material weaknesses (if any)
•• Management’s assessment of any significant matters, considering the potential

impact on financial reporting and need for corrective action
•• The quality of financial reporting and disclosures
•• The hiring of and payment to the external auditor
61 Audit committee members typically demonstrate independence of thought and sub-

stance by absence of any material financial or other personal ties to the company, which
could impede their ability to provide unbiased guidance and oversight.
62 The responsibilities of the board and audit committee are to oversee management’s
performance of internal control. The board must therefore retain objectivity in relation
to management.
Example: Reviewing and Documenting Key Activities of the

Audit Committee
63 Every year, the board of directors of Northern Power, a distributor of electricity, com-
missions an effectiveness evaluation of its audit committee relative to its charter. The
charter sets out the responsibilities and key activities of the committee. Under the
charter, the committee solicits from management and independent reviewers as neces-
sary the information required to:
•• Oversee the quality and reliability of financial reporting and disclosures
•• Understand the key risks facing the organization and the processes management
uses to identify, assess, and manage risks, considering internal audit findings,
litigation, compensation schemes, regulation, and compliance
•• Evaluate organizational behavior, culture, and adherence to standards of conduct
•• Understand how management and the external auditor evaluate materiality for
financial reporting purposes
•• Assess reasonableness and appropriateness of critical accounting policies of

the company
5 In practice, many of the activities of the board of directors included here would be carried out by one of its
committees, such as the audit committee.

•• Confirm or reject the basis for management estimates and proposed accounting
policy changes before approving
•• Evaluate, retain, or change external auditors
•• Review audit plans
•• Review management’s assessment of internal control over external

financial reporting
64 The results of the evaluation are used to determine whether the roles and responsibili-
ties of the committee have been met and could result in committee member changes or
impact remuneration. In addition to the annual review, every three years the company
conducts a benchmark review against leading practices and refines its charter,
as appropriate.
Approach: Establishing Policies and Practices for Meetings between

the Board of Directors and Management

• Establishes Oversight Responsibility 65 The board of directors reviews and approves policies and practices that support the
Applies Relevant Expertise performance of internal control across the business in regular meetings between man-
Operates Independently agement and the board. The processes and structures particularly relevant to the audit
committee of the board are those that provide:
Internal Control •• Appropriate forums to enable board members to ask probing questions
of management
•• A calendar that establishes the timing and frequency of meetings

with management
•• Expected practices to keep board members current on both emerg-

ing and adopted accounting standards and their impact on the entity’s
financial statements
•• Procedures to review management’s development and performance of internal

control over external financial reporting
•• Authority to engage experts as needed and oversight to ensure that management

appropriately resolves matters raised by the board
•• Criteria and procedures for calling special and/or urgent meetings as necessary
•• Allocation of time in board meetings for discussions with external advisors, inter-
nal and external auditors, and legal counsel without management being present
66 The policies and practices are updated as needed to reflect changes in internal and
external expectations, including rules and regulations.
Example: Establishing an Audit Committee Meeting Calendar

67 The audit committee of Outer Limits Innovations, an aerospace control systems sup-
plier, uses its charter as guidance when setting its meeting dates and agendas. Fred
Krahn, the chair of the committee, plans for at least one meeting during the year at

which each responsibility set forth in the charter is discussed. This practice helps the
audit committee cover all relevant responsibilities, and helps management anticipate
and plan for the committee’s expectations. The meeting calendar, which is shown
below, is periodically reassessed to adjust for emerging regulatory and technical
matters that could affect the company or the industry.
Frequency Planned Meeting
Quarter
A E AN
1 2 3 4
Audit Committee Issues
Report of results of annual independent audit to the board

Appointment of the external auditor
Approval of external auditor fees for upcoming year
Review of annual proxy statement audit committee report
Assessment of the adequacy of audit committee charter
Approval of audit committee meeting plan for the upcoming year,
confirm mutual expectations with management and the auditor

Audit committee self-assessment
Approval of guidelines for engagements of external auditors for
other services (pre-approval policy)
Approval of any non-audit services provided by outside auditors
Report of external auditor pre-approval status/limits
Review of procedures for handling financial reporting errors
or irregularities
Oversees fraud risk assessment process
Approval of minutes of previous meeting
Report quarterly matters to the board (chair)
Schedule executive session of committee members
Other matters
Financial Management
Annual Report, 10-K, and Proxy Statement Matters

Quarterly report earnings review with management and external
auditor, pre-approval of external auditor professional activities
Assessment of system of internal control
Status of significant accounting estimates, judgments and special
issues (e.g. major transactions, accounting changes, SEC issues,
etc.)
Other matters (adequacy of staffing, succession planning, etc.)
A = Annually E = Each Meeting or Conference Call AN = As Necessary

Example: Preparing Effectively for Meetings

68 The audit committee of Millennium Lighting, a manufacturer of lighting and ventila-
tion equipment, is chaired by Janis White, a CPA with financial reporting expertise and
previous public accounting experience. Ms. White regularly distributes to the committee
members any updates from management on technical matters.
69 Before each committee meeting, she circulates the draft agenda both to the commit-
tee members and the external auditors to solicit their input on any additional technical
accounting agenda items they would like to discuss. Ms. White is committed to keeping
open channels of communication with the external audit engagement partner and the
company’s chief audit executive to ensure she receives timely updates on any discus-
sions occurring with management as technical matters emerge. Internal audit, litigation,
and corporate social responsibility are a few of the areas that are regularly solicited for
input by the board or audit committee.
Approach: Identifying and Reviewing Board of Director Candidates

Establishes Oversight Responsibility 70 The board of directors periodically assesses and confirms its collective ability to provide
• Applies Relevant Expertise effective oversight. Through independent review and self-assessment it determines the
• Operates Independently adequacy of its composition, whether it has sufficient independent members, and the
Provides Oversight for the System of appropriate expertise.
Internal Control
71 To meet the entity’s external financial reporting objectives, the board of directors identi-

fies certain board candidates who are independent of both management and the entity
and who have requisite financial reporting and other relevant expertise. These members
are typically assigned to the audit committee.6 Such expertise may be established
through professional networks and organizations and by educational institutions whose
missions are aligned to the advancement of the financial reporting profession.
72 The board reviews the results of due diligence performed on potential board candi-
dates and confirms their competence and ability to remain unbiased. The procedures to
ensure that potential board members meet the defined criteria may include:
•• Evaluating the key risks facing the organization and accordingly defining board
member profile requirements
•• Performing background checks and obtaining independent references
•• Reviewing current affiliations and directorships to ensure independence relative to

management and the entity
•• Considering skills and expertise, ranging from financial to regulatory and various
technical knowledge needed to understand the issues that could affect the com-
pany’s external financial reporting
•• Validating that any credentials and certifications held demonstrate an achieved

competence level
6 Standard setters, regulators, or listing agencies may have specific requirements regarding director inde-
pendence, qualifications, and the makeup of the audit committee.

•• Reviewing information about financial and other relationships with the company,
its external auditors, or management
•• Using an independent nominating committee or search firm to oversee due dili-

gence procedures
•• Evaluating periodically the due diligence procedures used for identifying potential
directors, including checking that an individual director’s certifications are com-
plete, up-to-date, and comply with the entity’s ethics guidelines and indepen-
dence rules
Example: Changing the Board Composition of a Closely

Held Company
73 Giante Ore is a mining exploration company whose shares are traded on an “over-
the-counter” bulletin board. Giante Ore has long maintained a board of directors that
includes three of the CEO’s family members and three outside, but not independent,
directors: the company’s outside legal counsel, a venture capitalist, and a personal
friend of the CEO.

74 Giante Ore recognized that it needed to strengthen its control environment and board
effectiveness. To that end, it revisited its board structure. The three relatives and one
personal friend of the CEO left the board and have been replaced by four independent
directors, all of whom are financially literate. One of the four has specific financial exper-
tise. These directors have now been appointed to a newly formed audit committee with
its responsibilities set forth in a charter.
Example: Assessing and Disclosing Director Qualifications

75 When Greene Inc. needs to identify new members for its board, it follows a detailed pro-
cedure to ensure the best possible candidates are chosen. The nominating committee
works with the human resources department, the legal department, and an independent
executive search firm to identify candidates and conduct due diligence in support of
the interest of the company in its short- and longer-term objectives. The key skills it has
identified are financial literacy, liquidity risk management expertise, business continuity
planning, and corporate social responsibility reporting experience that reflects the busi-
ness performance expectations of the company’s stakeholders.
76 The same team conducts an annual review to ensure that board members continue
to have the requisite competence and independence given the entity’s stakeholder
needs. The senior management of Greene Inc. provides the results of the review in its
public filings.

Approach: Reviewing Management’s Assertions and Judgments

Establishes Oversight Responsibility 77 The board demonstrates an appropriate level of skepticism of management’s assertions
• Applies Relevant Expertise and judgments that affect financial reporting by asking probing questions. In particular,
Operates Independently the audit committee of the board seeks clarification and justification of the company’s
process for:
Internal Control •• Selecting and implementing accounting policies

•• Determining critical accounting estimates
•• Making key assumptions used in the application of technical accounting and

reporting matters
•• Evaluating other risks facing the organization, with the potential impact on finan-
cial reporting
Example: Reviewing Financial Statement Estimates

78 Future Fabrications manufactures specialty polymer products. The audit commit-
tee meets regularly with management to review the reasonableness of management’s
assumptions and judgments used to develop significant estimates. The committee then

meets privately with the external auditor to discuss its assessment of management’s
estimates and the related impact on financial reporting.
79 This practice is carried out for all assumptions related to key financial statement
accounts, disclosures, and relevant assertions. For example, for Future Fabrication’s
annual goodwill evaluation, management provides relevant information regarding any
specialists engaged to assist the company, key judgments and assumptions included
in the company’s discounted cash flow model, plausible sensitivity scenarios that were
considered, and confirmation of the appropriate technical accounting standard applied.
Approach: Meeting with Auditors

Establishes Oversight Responsibility 80 The audit committee of the board meets regularly with internal and external auditors, in
Applies Relevant Expertise private when necessary, to review and provide oversight of:
Operates Independently •• Key risks facing the organization
•• Audit scope and testing plans
Internal Control
•• Basis for definition of materiality threshold
•• Changes in accounting policies
•• Assumptions in models and calculations
•• Resources and staffing
•• Significant audit findings
•• Quality and reliability of financial reporting and disclosures

Example: Interacting with Auditors

81 Sara Greenburg is the chair of the audit committee of Seaworthy Solutions, a marine
construction services provider. She arranges for the committee to meet quarterly with
the external auditor to discuss a wide range of issues such as audit scope, testing
plans, internal control over external financial reporting, quality of financial reporting,
and audit findings and recommendations. She is responsible for coordinating the audit
committee’s evaluation of the external auditor. She bases her evaluation on a number
of considerations, including the firm’s reputation, the qualifications of the audit partner
and team, knowledge and experience in the company’s industry, and the firm’s quality
control procedures. Ms. Greenburg believes that these interactions, supplemented as
needed with interim conversations, effectively positions the audit committee chair to
monitor the external auditor’s performance and make an informed judgment on any
need to modify or terminate the relationship.
82 The audit committee also regularly meets with the Seaworthy’s chief audit executive
to ensure that the same oversight objectives of the internal audit function are attained.
The chief audit executive has a direct reporting line to the audit committee to enable an
objective mindset and facilitate the escalation of issues.

Author’s note: This example was taken from a public company in the US. Standard setters, regulators, or spe-
cific listing agencies may have specific requirements regarding composition and operating responsibilities of
the audit committee. These may vary based on the situation, and the facts and circumstances of this example
influenced the responsibility and the frequency of meetings.
Approach: Considering Whistle-Blower Information about Financial

Statement Errors and Irregularities
83 The audit committee considers information obtained from the company’s whistle-blower Establishes Oversight Responsibility
and anti-fraud programs (or similar processes) to monitor the risks in misstatements Applies Relevant Expertise
in financial reporting. These may include risks of inappropriate acts by staff and man-
Operates Independently
agement override of controls. The audit committee evaluates management’s analysis
of significant matters, potential impact on financial reporting, and corrective actions
Internal Control
being taken.

Example: Assessing the Potential of Management Override

84 Generation Now is an electricity transmission and distribution company. At least annu-
ally, its audit committee discusses in executive session its assessment of the risks
of management override of internal control, including motivations, opportunities, and
rationalizations for management override and how those activities might be concealed.
The committee reviews independent evaluations of the functioning of the company’s
whistle-blower process and related reports and the fraud hotline, and from time to time
it also makes inquiries of those managers who are not directly responsible for financial
reporting (including personnel in sales, procurement, and human resources, among
others). It also collects information whenever any concerns are expressed about ethics
or possible management override of internal controls. The process of questioning con-
tinues until resolution is reached.

Establishes Structure, Authority, and Responsibility

Principle 3. Management establishes, with board
oversight, structures, reporting lines, and appropriate
authorities and responsibilities in the pursuit of objectives.
Points of Focus
•• Considers All Structures of the Entity—Management and the board of direc-

tors consider the multiple structures used (including operating units, legal enti-
ties, geographic distribution, and outsourced service providers) to support the
achievement of objectives.
•• Establishes Reporting Lines—Management designs and evaluates lines of

reporting for each entity structure to enable execution of authorities and responsi-
bilities and flow of information to manage the activities of the entity.

•• Defines, Assigns, and Limits Authorities and Responsibilities—Management
and the board of directors delegate authority, define responsibilities, use appro-
priate processes and technology to assign responsibilities, and segregate duties
as necessary at the various levels of the organization:
-- Board of Directors—Retains authority over significant decisions and reviews

management’s assignments and limitations of authorities and responsibilities
-- Senior Management—Establishes directives, guidance, and control to enable

management and personnel to understand and carry out their internal control
responsibilities
-- Management—Guides and facilitates the execution of senior management

directives at the entity and its subunits
-- Personnel—Understands the entity’s standard of conduct, assessed risks to

objectives, and the related control activities at their respective levels of the
entity, the expected information and communication flow, and monitoring
activities relevant to their achievement of the objectives
-- Outsourced Service Providers—Adheres to management’s definition of the

scope of authority and responsibility for all non-employees engaged

Control Environment | Establishes Structure, Authority, and Responsibility
Approach: Defining Roles and Reporting Lines and Assessing Them

for Relevance
86 Senior management prepares organizational charts to document, communicate, and • Considers All Structures of the Entity
enforce accountability for the achievement of the entity’s financial reporting objectives. • Establishes Reporting Lines
The organizational charts can be used to:
• Defines, Assigns, and Limits Authorities and
•• Set forth assignments of authority and responsibility Responsibilities

•• Ensure duties are appropriately segregated
•• Establish reporting lines and communication channels
•• Define the various reporting dimensions relevant to the organization
•• Identify dependencies for roles and responsibilities involved in financial reporting

as well as those accountable for external parties
87 Each unit or department within the entity that is relevant to external financial report-
ing aligns its roles and responsibilities to processes supporting the financial reporting

objectives. Senior management and the board of directors verify that accountability
and information flow within each of the various organizational structures (by business
segment, geographical location, legal entity, or other) continually support the achieve-
ment of the entity’s existing financial reporting objectives. Existing structures are peri-
odically assessed for relevance considering changes in the entity or the environment in
which it operates to ensure such alignment.
Example: Reorganizing to Support Control Structure

88 Before Harmony Homes Real Estate became a public company, a wide range of the
employees reported to the owner and CEO, Milton Chang, and the business structures
in the US and in Asia were loosely connected. During the plans to go public, Mr. Chang,
with the board’s guidance, took steps to strengthen the organizational structure to
better support both operations and financial reporting objectives. Management created
three departments to oversee its core business activities: sales and customer service,
purchasing/inventory, and production. Geographic governance structures were also
established to oversee operations by jurisdiction and facilitate reporting to local regula-
tors and other stakeholders. The managers charged with leading each of these depart-
ments and territories, as well as the managers of key staff functions, documented each
person’s responsibility in the processes. Job descriptions, including internal control
responsibilities, were developed to support full understanding of each person’s role.
89 The clarity of roles helps to ensure responsibilities are carried out in support of the
organization’s objectives. They also provide the basis for risk assessment, control
activities, information and communication, and monitoring activities along different
dimensions simultaneously.

Example: Redefining Roles with CEO and Board Input

90 Due to significant changes within the company and the industry, Pieter Jenssen, CEO
of transportation services provider General Trucking, recognized the need to redefine
the role of each position within the company’s mid- to high-level management team,
especially within the finance and accounting function. His initiative was launched at
an off-site meeting where the goals and objectives of the business were reviewed and
realigned with managers’ specific roles and responsibilities, including those related to
the financial reporting process. Two board members attended the meeting to serve as
a sounding board, and all participants reached a shared understanding on how they
will function and interact with one another in the future. The results of the meeting were
communicated to other managers throughout the organization. The communication
included a description of organizational lines by product line, geography, and manage-
ment structure. It also included associated roles, responsibilities, and communication
procedures, incorporated into policies that were made readily accessible on the com-
pany’s intranet.

Approach: Defining Authority at Different Levels of Management
Considers All Structures of the Entity 91 The board of directors outlines its oversight authority for financial reporting over senior
Establishes Reporting Lines management through its charter. When assigning authorities and responsibilities, man-
agement considers the impact on the control environment and the importance of effec-
Responsibilities tively segregating duties. Policy documents define cascading levels of authority, checks,
and balances for authorizing transactions, and accounting and reporting of financial

results. Such authority and responsibility is deliberately limited in order to balance the
need for the efficient achievement of objectives against the risks that could result from
unmonitored inappropriate conduct. Management empowers employees to correct
problems or implement improvements in their assigned business process as necessary.
Example: Maintaining an Authority and Approval Matrix

92 A waste management company maintains policies that detail the monetary commitment
and transaction approval authorities of its managers on a per occurrence basis. Manag-
ers who exceed their individual transactions authority must obtain approval from the
appropriate higher-level management, which in some cases includes the board of direc-
tors. These authority and responsibility policies exist for a broad range of the company’s
business functions, including mergers and acquisitions, sales and marketing, purchas-
ing, risk management, labor, capital expenditures (including landfills), IT expenditures,
and leases. The policies are updated when necessary to reflect changes in the busi-
ness, and any revisions require the approval of the chief accounting officer.

Control Environment | Establishes Structure, Authority, and Responsibility
Approach: Maintaining Job Descriptions and

Service-Level Agreements
93 Based on the delegated authority levels, management maintains job descriptions to Considers All Structures of the Entity
outline financial reporting responsibilities, and updates them when needed. In addition, Establishes Reporting Lines
management provides sufficient direction to ensure that employees recognize their
responsibility for internal control and the importance of applying appropriate diligence Responsibilities
and business judgment when they carry out their assigned job responsibilities.

For key financial reporting positions, the board of directors reviews management’s
descriptions of the related authorities and responsibilities and considers how those
positions affect the strength of internal control over external financial reporting.
When applicable, the responsibilities of externally sourced support personnel are out-
lined through service-level agreements, specifically targeting timeliness and the quality
of financial reports generated.
Example: Aligning Roles and Responsibilities with Objectives

94 The senior management at MNO Games, a games software developer, has recognized

that the company’s recent significant growth is causing many of the roles and respon-
sibilities of its management executives to be no longer relevant. Responsibilities of the
controller and CFO overlap, systems for product being sold through new channels are
not adequately reviewed, and the CEO is not effectively communicating initiatives and
agreements across the senior management team.
In response, the senior managers have initiated a project to realign responsibilities

among its leadership team. The goals are to adequately support financial reporting
objectives, with clear lines of reporting supported by new written job descriptions. The
project has already resulted in a new company policy for MNO Games that requires
each business unit manager to maintain the updated job descriptions and organizational
charts depicting positions and lines of reporting within the unit.
Example: Maintaining Control while Engaging Outside

Service Providers
95 SureSafe provides identify-theft protection and credit management services to credit
card companies and has decided to outsource its payroll and 401(k) plan administra-
tion to capitalize on cost savings, ease access to relevant specialists for technical and
administrative questions, and improve segregation of duties between its key payments
and collections processes.
96 SureSafe identified a small reputable company, J.K. Green and Associates, as one
that would meet their processing, reporting and internal control needs. The service-
level agreement signed by both parties specifies each party’s expectations and
responsibilities for the services provided and internal control over the outsourced
business processes.

Approach: Defining the Role of Internal Auditors

Considers All Structures of the Entity 97 In companies with formal internal audit departments (typically those that are larger or
• Establishes Reporting Lines publicly listed), the board of directors empowers the internal audit department to carry
out its purpose, authority, and responsibility as established in its charter. The internal
Responsibilities audit charter establishes functional and administrative reporting lines, which include
direct access to the audit committee and/or the board of directors. The audit committee

also is actively involved in overseeing the internal audit plan. The board also oversees
the compensation structures for the chief audit executive and the internal audit depart-
ment to ensure they are structured in a manner that supports the department’s need for
objectivity.
Example: Reviewing and Approving the Internal Audit Plan

98 Sam Murphy, the chief audit executive officer of Pine Tree Real Estate, annually pres-
ents an internal audit plan to the CEO and audit committee for review and approval. The
audit plan includes the scope, work plan, staffing, and budget for the coming year, as
well as any modifications needed in the charter to define roles and responsibilities.

Control Environment | Demonstrates Commitment to Competence
Demonstrates Commitment to Competence

Principle 4. The organization demonstrates a commitment
to attract, develop, and retain competent individuals in
alignment with objectives.
Points of Focus
•• Establishes Policies and Practices—Policies and practices reflect the organi-

zation’s expectations of competence necessary to support the achievement of
objectives.
•• Evaluates Competence and Addresses Shortcomings—The board of directors

and management evaluate competence across the organization and in outsourced
service providers in relation to established policies and practices, and acts as
necessary to address shortcomings.

•• Attracts, Develops, and Retains Individuals—The organization provides the
mentoring and training needed to attract, develop, and retain sufficient compe-
tent personnel and outsourced service providers to support the achievement of
objectives.
•• Plans and Prepares for Succession—Senior management and the board of

directors develop contingency plans for assignments of responsibility important
for internal control.

Approach: Establishing Required Knowledge, Skills, and Expertise

• Establishes Policies and Practices 100 The audit committee of the board reviews and approves the competency requirements
Evaluates Competence and Addresses of all individuals serving in key financial reporting and internal audit roles and for all
Shortcomings members of the audit committee. These are based on applicable laws and regulations,
Attracts, Develops, and Retains Individuals
and on the expertise needed for applying the entity’s existing policies and practices
related to external financial reporting.
Plans and Prepares for Succession
101 Management develops and maintains job descriptions that reflect its values and the
knowledge, skills, expertise, and credentials needed to effectively carry out responsibili-
ties for each financial reporting position.
102 The finance department regularly reviews the entity’s accounting and reporting
policies and practices, and updates these as necessary to keep pace with inter-
nal expectations and external factors, including changes in technical standards and
regulatory requirements.
103 The human resources department also periodically updates materials outlining the

company’s policies and procedures on attracting, training, coaching, evaluating, and
retaining personnel.
Example: Periodically Reviewing Policies

104 Asha Sandhu leads the human resources department of NetTech Industries, a provider
of networking technology platforms. She is responsible for ensuring that roles and
responsibilities of financial reporting personnel and related job descriptions are aligned
to the company’s accounting, reporting, and internal control policies and procedures.
105 As part of annual goal-setting discussions, Ms. Sandhu and her department assess the
extent to which employees are aware of their job responsibilities and current policies
and practices. They use the results to track progress and enhance existing communica-
tions and training programs.
Approach: Linking Competence Standards to Established Policies

and Practices in Hiring, Training, and Retention Decisions
• Establishes Policies and Practices 106 Policies and practices that represent the entity’s competence standards for financial
Evaluates Competence and Addresses reporting positions are used as a basis for human resource and employee compliance
Shortcomings activities, which may include:
• Attracts, Develops, and Retains Individuals •• Selecting and interviewing candidates
•• Performing background/reference checks

•• Making hiring, retention, promotion, and termination decisions
•• Developing training curricula
•• Setting certification expectations
•• Conducting exit interviews to uncover any concerns related to the entity’s internal
control over external financial reporting

Example: Recruiting and Retaining Key Financial

Reporting Positions
107 The CFO of La Porte, a garage door manufacturer, was looking to fill the position of con-
troller for its affiliate in France. The job requires someone with in-depth experience in
US public filing reporting compliance requirements, a high level of integrity, and sound
ethical values.
108 La Porte screened the candidate through interviews by a cross-section of leaders of

key departments, the human resources department running a background check, and
the CFO interviewing the candidate’s references. Upon being hired, the controller is
expected to participate in several relevant conferences throughout the year and main-
tain a current level of knowledge of industry and financial reporting matters.
Example: Defining Performance Expectations

109 A leading provider of consumer credit, Credit Safe, believes in establishing and rein-
forcing a culture in which its employees are aware of performance expectations and
requirements. To that end, annual performance objectives are established and docu-
mented for each employee. For example, employees working in finance and internal

audit roles are expected to either work toward obtaining a certification or attend a requi-
site amount of continuing education training to maintain existing certifications.
110 Credit Safe periodically evaluates every employee’s performance and tracks it against
established objectives. Management provides feedback and guidance to help employ-
ees achieve the objectives. At the end of each year, an employee’s performance is rated
as one of several categories: superior, exceeds expectations, meets expectations,
needs improvement, or unsatisfactory.
Approach: Identifying and Delivering Financial Reporting-Related

Training as Needed
111 Training needs are identified and delivered to targeted personnel. These address Establishes Policies and Practices
regulatory expectations, emerging accounting and reporting standards, and in-house • Evaluates Competence and Addresses
input on areas that require improvement. Training needs are reprioritized as neces- Shortcomings
sary in response to how often applicable changes occur, both within and outside • Attracts, Develops, and Retains Individuals
the organization. Plans and Prepares for Succession

Example: Implementing Complex Accounting Standards
112 Orex, a mining exploration company that makes extensive use of stock options in com-
pensating its senior employees, has been subject to a pronouncement on accounting
for stock compensation. Max Tellemann, the chief financial officer, and Arlene Shreve,
the company controller, attended an external training session on the pronouncement,
which included working through examples of how the standard would be applied in
various cases. Mr. Tellemann and Ms. Shreve assessed the suitability of their company’s
practices by benchmarking against market data and performing an impact analy-
sis based on expert opinions and trade publications that discuss expected impacts
and pitfalls.

113 This intensive training has provided senior management of Orex with the confidence
that their CFO and controller now have sufficient knowledge to make informed decisions
on the proper application of the standard. Documentation of the training attended has
been tracked and included in Ms. Shreve’s and Mr. Tellemann’s employee files.
Approach: Selecting Appropriate Outsourced Service Providers

Establishes Policies and Practices 114 Management identifies the required skills and experience necessary to support the enti-
• Evaluates Competence and Addresses ty’s external financial reporting objectives. It then decides whether to internally retain
Shortcomings people with these skills and experience or to outsource to a third party. The suitability
• Attracts, Develops, and Retains Individuals of a third party is determined not only by assessing skills and experience, but also by
considering the entity’s policies on using vendors and on ethical standards. The con-
tractual arrangement with the outsourced service provider captures these competence

requirements and provides the basis for the entity to periodically assess the outsourced
service provider’s continued commitment to competence.
Example: Retaining External Tax Assistance

115 Compu Services, a developer of analytical software products, currently has limited tax
accounting expertise among its staff. The finance director therefore sought to contract
with a third-party accounting firm, SMR Ledger, LLP, to review its tax provisions. SMR
Ledger is a different accounting firm from the Compu Services auditor.
116 For successful selection and use of the vendor’s services, management was careful to
verify that the vendor met the suitability standards set forth in Compu Services’ poli-
cies. Being impacted directly by the quality of the control procedures carried out by the
vendor, the CFO spends time with the vendor to understand any assumptions used in
models or calculations, particularly as they may impact financial reporting. Indeed, while
Compu Services’ management chooses to outsource certain tax activities, it remains
responsible for the effectiveness of relevant controls regardless of where they are oper-
ated. The company therefore requests annual independent certifications of the vendor’s
internal control effectiveness.
Approach: Evaluating Competence and Behavior

Establishes Policies and Practices 117 To maintain and advance the entity’s expected competence and behavioral standards,
• Evaluates Competence and Addresses management develops policies and conducts practices that may include:
Shortcomings
•• Developing incentives and rewards that consider the multiple dimensions of
Attracts, Develops, and Retains Individuals conduct and performance
•• Reinforcing expectations of continued demonstration and strengthening of

expected levels of competence
•• Ensuring individual and team goals in support of the achievement of the enti-
ty’s objectives are defined, use observable metrics, and are communicated to
each employee

•• Developing a performance appraisal process that confirms employee knowledge

of both their progress against their goals and their status within the organization
•• Conducting periodic performance reviews and evaluating employees relative to

their assigned roles to confirm that the employees’ skills are appropriate for their
current job responsibilities
•• Making appropriate advancement or termination decisions based on

performance reviews
•• Changing the performance appraisal process as needed based on lessons

learned or changes in strategy and operating objectives
•• Continually endorsing behavior that is consistent with competence standards, and

discouraging inconsistent behavior
118 Using the same criteria, the board of directors evaluates the competencies of individu-
als serving in key financial reporting roles, such as the CEO and CFO.
Example: Periodically Assessing Performance

119 City Government periodically reviews the performance of its employees who are
responsible for owning, executing, or testing financial reporting controls. Performance is
evaluated against expectations that are established at the beginning of each year. The
progress achieved on needed improvements is reviewed with employees at the end of
each quarter, and a more formal annual review process occurs following the year-end
reporting cycle. An employee’s career advancement is based on the overall perfor-
mance rating. Management identifies specific areas for improvement and professional
growth, which employees can address with training and development steps, as jointly
agreed with the respective manager in the context of City Government’s finance func-
tion and overall performance objectives.
Example: Audit Committee Review of Managers’ Roles

120 The bylaws of Lead Products Co. specify the responsibility of the audit committee of
the board for reviewing the principal roles and responsibilities of key financial reporting
senior management. To this end, the chair of the audit committee meets annually with
the company’s human resources director, chief audit executive, and legal counsel to
review the roles, responsibilities, and performance of the various company managers.
The review focuses on aligning respective managerial responsibilities with Lead Prod-
ucts’ organization chart, and the managers’ expertise and experience in carrying out
the responsibilities.

Approach: Evaluating Sufficiency and Competency of

Finance Personnel
Establishes Policies and Practices 121 Senior management evaluates the sufficiency and competency of the personnel who are
• Evaluates Competence and Addresses involved in recording and reporting financial information, and in designing and develop-
Shortcomings ing financial reporting systems including underlying IT systems. Senior management
Attracts, Develops, and Retains Individuals assesses the department’s ability to identify issues, articulate positions supported by
the relevant literature, and stay abreast of technical financial reporting developments.
Considerations when assessing the adequacy and competency of financial reporting

personnel include overall technical skills, nature and frequency of their training, and the
number of personnel dedicated to financial reporting.
Example: Assessing Key Financial Reporting Personnel

122 The senior management of Tall Tree Finance, an investment bank and institutional secu-
rities company, annually assesses the ability of its key financial reporting personnel to
understand and manage effectively the company’s current business activities, related
accounting questions, and IT implementation challenges. The audit committee oversees
this assessment.

123 In particular, the assessment considers how adequately personnel respond to emerging
accounting, reporting, and internal control issues. Senior management uses the results
of this assessment to make decisions on staff training, reassignments, or other organi-
zational changes.
Example: Aligning Competencies with Key Financial

Reporting Positions
124 The start-up company of Wireless Data Communications has seen its revenue double
over the last several years, and business transactions and processing have become
significantly more complex. Because of these evolving corporate needs due to the rapid
growth, it is essential for employee competencies in key financial reporting positions to
be aligned with roles and responsibilities.
125 Consequently, the CEO, CFO, and vice-president of human resources together annu-
ally review employee job descriptions and performance assessments. During a recent
review, they determined that the company’s controller, hired initially to perform basic
accounting and bookkeeping functions, no longer had the expertise needed for the
associated financial reporting responsibilities. The company has now assigned the con-
troller to a position better suited to his skills, and hired an individual with the requisite
competencies as controller.

Approach: Developing Alternate Candidates for Key Financial Re-

porting Roles
126 The board of directors identifies the essential roles for the functioning of the business, Establishes Policies and Practices
including the CEO and the CFO, deemed most important to the achievement of the Evaluates Competence and Addresses
entity’s financial reporting objectives. For each of those roles, management defines Shortcomings
succession plans to ease any future transition and to mitigate the risk of not meeting Attracts, Develops, and Retains Individuals
financial reporting objectives. The board of directors oversees this process to ensure
• Plans and Prepares for Succession
that management has properly assessed and managed the risks associated with suc-

cession planning.
Example: Addressing Succession Planning

127 North-to-South Healthcare has an aging workforce and realizes it needs a succession
plan in place. Over the past year it developed a “talent management strategy,” which
formalizes a succession planning framework and a process and leadership develop-
ment program. The succession plan identifies those positions and external parties that
are critical to the organization.
128 North-to-South has assessed current personnel to determine potential candidates for

those critical positions in the future. The company has developed customized com-
petency models for each of the critical positions and assessed the competencies of
current staff as possible future candidates. For each of the identified candidates, an
individual development plan and a leadership development program has been estab-
lished. These include experiential learning programs and executive mentoring programs.
129 For outsourced service providers or business partners critical to the performance of
external financial reporting (such as information technology, payroll, accounts payable
processing), North-to-South has defined contingency plans to allow for alternative
arrangements in the event that such external parties become unavailable. The manage-
ment member responsible for the relationship is also responsible for maintaining and
executing the contingency plan, as necessary.
130 The talent management strategy has allowed North-to-South to confidently plan for
the future.

Enforces Accountability
Principle 5. The organization holds individuals
accountable for their internal control responsibilities in the
pursuit of objectives.
Points of Focus
•• Enforces Accountability through Structures, Authorities, and Responsibilities—

Management and the board of directors establish the mechanisms to communi-
cate and hold individuals accountable for performance of internal control respon-
sibilities across the organization and implement corrective action as necessary.
•• Establishes Performance Measures, Incentives, and Rewards—Management

and the board of directors establish performance measures, incentives, and
other rewards appropriate for responsibilities at all levels of the entity, reflecting

appropriate dimensions of performance and expected standards of conduct, and
considering the achievement of both short-term and longer-term objectives.
•• Evaluates Performance Measures, Incentives, and Rewards for Ongoing Rele-

vance—Management and the board of directors align incentives and rewards with
the fulfillment of internal control responsibilities in the achievement of objectives.
•• Considers Excessive Pressures—Management and the board of directors

evaluate and adjust pressures associated with the achievement of objec-
tives as they assign responsibilities, develop performance measures, and
evaluate performance.
•• Evaluates Performance and Rewards or Disciplines Individuals—Management

and the board of directors evaluate performance of internal control responsibili-
ties, including adherence to standards of conduct and expected levels of compe-
tence, and provide rewards or exercise disciplinary action as appropriate.

Control Environment | Enforces Accountability
Approaches: Defining and Confirming Responsibilities

132 Management develops descriptions of various roles to reinforce its responsibility for • Enforces Accountability, through Structures,
effective internal control over external financial reporting. In pursuit of the entity’s objec- Authorities, and Responsibilities
tives, the board of directors and senior management maintain a philosophy and operat- Establishes Performance Measures,
ing style that demonstrate a strong commitment to ethics, integrity, and competence. Incentives, and Rewards
Evaluates Performance Measures,
133 Periodically, the CEO and CFO, as the parties ultimately responsible for internal control, Incentives, and Rewards for Ongoing
request individuals within the entity to confirm accountability and represent that they Relevance
have fulfilled their internal control responsibilities during any given period of time, high- Considers Excessive Pressures
lighting any exceptions.
• Evaluates Performance and Rewards or
Disciplines Individuals
Example: Cascading Responsibilities throughout the Organization
and Measuring Results
134 Auto Services is a publicly traded multinational automotive manufacturing, leasing, and
sales organization that requires its employees to be aware of the risks inherent in their
day-to-day business decisions.

135 Representing its products adequately to its customers, saying no to bribes and other
illicit practices, delivering timely products or services in accordance with quality stan-
dards are the explicit expectations of the company and of each one of its representa-
tives. Management communicates and reinforces these messages continually and holds
its people accountable to these measures in their day-to-day decisions and overall risk
and performance results, which it tracks proactively through client satisfaction dash-
board reports and reactively through incident reporting.
136 More specifically, goals are defined, performance is evaluated, and employees are held
accountable within the local organizational structure. For instance, a sales manager in
South Africa is accountable to the company as a whole for its core values and defin-
ing brand, yet performance, mentoring, rewards, and sanctions are managed within the
business line at the local level where the employee is based.
Approach: Developing Balanced Performance Measures, Incentives,

and Rewards
137 Senior management defines performance measures, incentives, and rewards that are: Enforces Accountability, through Structures,
Authorities, and Responsibilities
•• Aligned with the entity’s ethical values
• Establishes Performance Measures,
•• Developed at all levels of the entity that management deems necessary to support Incentives, and Rewards
and ensure accountability toward meeting both the entity’s short-term and longer- Evaluates Performance Measures,
term objectives Incentives, and Rewards for Ongoing
Relevance
•• Balanced to include both financial and non-financial measures
Considers Excessive Pressures
•• Incorporated into the entity’s hiring, evaluation, and promotion structures Evaluates Performance and Rewards or

138 Senior management subsequently reports to the board what factors were considered
in developing the performance measures, incentives, and rewards and how they are
expected to drive the desired behavior.
Example: Defining and Communicating the Basis for Reward

139 Modern Financial Services has implemented a rewards system that requires the
achievement of defined performance measures and encourages departments to
monitor the effectiveness of their internal control systems and to self-report possible
control deficiencies or opportunities for enhancement. This encouragement comes in
the form of a policy that gives departments credit in the internal audit grading system
for self-reported deficiencies. Any deficiencies that are identified through internal audit
procedures, rather than through a department’s monitoring efforts, are counted against
the score.
140 The credit does not preclude the internal audit department from reporting specific defi-
ciencies to management or the board when warranted, but it does positively affect the
grading system, which can affect departmental compensation and benefits. The result
is that Modern Financial Services is more likely to identify control deficiencies before

they can become material to the organization.
Approach: Evaluating Performance Measures for Intended Influence

Enforces Accountability, through Structures, 141 The board of directors and management periodically evaluate the appropriateness of
Authorities, and Responsibilities performance measures used to determine whether they have the intended influence on
Establishes Performance Measures, how people respond to pressures, incentives, and rewards. This evaluation may include:
Incentives, and Rewards
•• Reassessing the relevance of performance measures considering industry trends,
• Evaluates Performance Measures,
regulatory changes, or changes in the entity’s objectives
Incentives, and Rewards for Ongoing
Relevance •• Considering past financial errors, ethical violations, and instances of non-compli-
• Considers Excessive Pressures ance and whether the established measures could have caused excessive pres-
Evaluates Performance and Rewards or sures to override controls
•• Engaging external parties to conduct benchmarking and to interview employees
•• Monitoring the changing sources of threats that cause pressure to bypass estab-
lished controls or take shortcuts
•• Considering whether the selection of accounting policies has been unduly influ-
enced by the established performance measures
•• Using the assessment to make changes in performance measures and associated

hiring, evaluation, and promotion structures
142 The board of director’s oversees the periodic assessment to ensure it has been com-
pleted, and may subsequently approve compensation plans. The board also provides
oversight to ensure that the performance measures and compensation plans estab-
lished for senior management are appropriately aligned with the entity’s strategic objec-
tives and balanced to promote the desired accountability without causing excessive
pressure that could lead to fraudulent financial reporting.

Control Environment | Enforces Accountability
Example: Establishing and Overseeing Performance Measures, In-

centives, and Rewards
143 The board of directors of A-Z Corp. has established a human resources compensa-
tion committee, which meets to establish compensation for the executive officers. It
has been granted substantial discretion to determine all other bonuses under approved
incentive plans.
144 The compensation committee routinely reviews the performance goals and awards for
ongoing relevance and to determine whether they create unnecessary pressures or
unintended consequences. It continually focuses on identifying those short-term sales
objectives that may cause management to take undue risk, cut corners, or commit fraud
that could harm the company’s sustainable growth objectives.
145 Based on these reviews, goals and awards are modified as necessary, and changes are
approved by the board of directors annually. The performance goals and awards consist
of the following and are subject to audit:
•• Earnings per share
•• Audit scores

•• Customer care
•• Efficiency ratio
•• Stock price (peer group comparison)
146 In addition, individual employee performance goals are determined annually in discus-
sion between the employee and the manager. They are then submitted to the human
resources department for review, and to the compensation committee for approval.
147 Any incentive compensation that is approved and ratified by the board is distributed to
individuals annually.
Approach: Linking Compensation and Other Rewards

to Performance
148 Management designs objective employee evaluation and compensation systems that Enforces Accountability, through Structures,
periodically provide individual rewards, or disciplinary actions, as necessary. Deci- Authorities, and Responsibilities
sions about both rewards and disciplinary actions are based on established objectives, Establishes Performance Measures,
including the individual’s adherence to the standards of conduct and performance Incentives, and Rewards
toward the entity objectives regarding internal control over external financial reporting. Evaluates Performance Measures,
Incentives, and Rewards for Ongoing
Relevance
Example: Aligning Incentives with Ethics and Values
Considers Excessive Pressures
149 Timber Co., a forest products company, structures its bonus plan to have 30% of the
potential incentive award directly related to the demonstration of the company’s core • Evaluates Performance and Rewards or
values. Information items that Timber Co. values are specific comments on how man-
agement does or does not reflect values are captured through employee feedback.

150 During the employee performance review and appraisal process, management provides
feedback about the extent to which each employee has performed in accordance with
the company’s core values of sound integrity and ethics.
Example: Providing Recognition for Suggestions Made to Enhance

Internal Control
151 Medic Quest, a private company that researches, develops, produces, and markets
medical scanning equipment, encourages its employees to identify and submit sugges-
tions for improving internal control, including internal control over financial reporting.
Employees are rewarded in the form of company awards and/or cash bonuses for ideas
that are used.

Components of Internal Control | Risk Assessment
3. Risk Assessment
Chapter Summary
152 Every entity faces a variety of risks from both external and internal sourc-
es. Risk is defined as the possibility that an event will occur and ad-
versely affect the achievement of objectives. Risk assessment involves a
dynamic and iterative process for identifying and assessing risks to the
achievement of objectives. Risks to the achievement of these objectives
from across the entity are considered relative to established risk toler-
ances. Thus, risk assessment forms the basis for determining how risks
will be managed. A precondition to risk assessment is the establishment
of objectives, linked at different levels of the entity. Management speci-

fies objectives within categories relating to operations, reporting, and
compliance with sufficient clarity to be able to identify and analyze risks
to those objectives. Management also considers the suitability of the
objectives for the entity. Risk assessment also requires management to
consider the impact of possible changes in the external environment and
within its own business model that may render internal control ineffective.
Principles relating to the Risk Assessment component
6. The organization specifies objectives with sufficient clarity to enable

the identification and assessment of risks relating to objectives.
7. The organization identifies risks to the achievement of its objectives

across the entity and analyzes risks as a basis for determining how
the risks should be managed.
8. The organization considers the potential for fraud in assessing risks

to the achievement of objectives.
9. The organization identifies and assesses changes that could

significantly impact the system of internal control.

6. The organization specifies objec- •• Identifying Financial Statement

tives with sufficient clarity to enable Assertions
the identification and assessment of
•• Specifying Financial Reporting
risks relating to objectives.
Objectives
•• Assessing Materiality
•• Reviewing and Updating Understand-

ing of Applicable Standards
•• Considering the Range of Entity

Activities
7. The organization identifies risks to •• Applying a Risk Identification Process

the achievement of its objectives
across the entity and analyzes risks •• Assessing Risks to Significant Finan-
as a basis for determining how the cial Statement Accounts
risks should be managed.
•• Meeting with Entity Personnel

•• Assessing the Likelihood and Signifi-
cance of Identified Risks
•• Considering Internal and External

Factors
•• Evaluating Risk Responses
8. The organization considers the •• Conducting Fraud Risk Assessments

potential for fraud in assessing risks
to the achievement of objectives. •• Considering Approaches to Circum-
vent or Override Controls
•• Considering Fraud Risk in the Internal

Audit Plan
•• Using Information Technology Tools
•• Reviewing Incentives and Pressures

Related to Compensation Programs
9. The organization identifies and •• Assessing Change in the External

assesses changes that could signifi- Environment
cantly impact the system of internal
control. •• Conducting Risk Assessments Relat-
ing to Significant Change
•• Considering Change through

Succession
•• Considering CEO and Senior Execu-

tive Changes

Risk Assessment | Specifies Relevant Objectives
Specifies Relevant Objectives

Principle 6. The organization specifies objectives
with sufficient clarity to enable the identification and
assessment of risks relating to objectives.
Points of Focus
•• Complies with Applicable Accounting Standards—Financial reporting objectives

are consistent with accounting principles suitable and available for that entity. The
accounting principles selected are appropriate in the circumstances.
•• Considers Materiality—Management considers materiality in financial statement

presentation.
•• Reflects Entity Activities—External reporting reflects the underlying transactions

and events to show qualitative characteristics and assertions.
Approach: Identifying Financial Statement Assertions

154 Management specifies objectives relating to the preparation of financial statements, • C
omplies with Applicable Accounting
Standards
including disclosures, and identifies significant financial statement accounts based on
the risk of material misstatement (which includes consideration of materiality). Manage- • Considers Materiality
ment identifes for each account and disclosure relevant assertions, underlying transac- • Reflects Entity Activities
tions and events, and processes supporting these financial statement accounts. The
entity uses financial statement assertions relevant to its financial statement accounts
and disclosures.
Example: Linking Accounts, Assertions, and Risks

155 As part of its risk assessment, the management of A-Middle Equipment, a 900-person
manufacturer of heavy-duty transmission equipment, uses the following financial report-
ing assertions:
•• Existence
•• Completeness
•• Rights and obligations
•• Valuation or allocation
•• Presentation and disclosure

156 A-Middle’s management considers the level of materiality when reviewing the compa-
ny’s activities and interim reports and determining whether all significant risks and
accounts have
Top-Down Riskbeen captured. This information is used as a guideline in focusing on
Assessment
detailed risks within each financial statement line item and disclosure. This approach is
illustrated below.
10-K
Financial
Statements
Accounts and disclosures mapped to financial statement assertions
F/S accounts Non-financial

mapped to processes; disclosures
processes mapped mapped to
to business units processes

Management
Revenue & Purchasing & Payroll & Legal Compliance Manu-
& Financial Treasury
Receivables Payables Benefits facturing
Reporting
Investor
Environment
Relations
Risk Assessment Documents

Risk Analysis Matrix by Financial
Statement Account and Disclosure
Account Risk Analysis Mapped to Business Processes
Applications mapped to underlying technology
Approach: Specifying Financial Reporting Objectives

omplies with Applicable Accounting 157
• C Management specifies a high-level financial reporting objective that forms the basis
Standards for all other sub-objectives. In specifying objectives, management has documented
Considers Materiality objectives that are specific, measurable, attainable, relevant, and time-bound (SMART).
Reflects Entity Activities Management, as part of internal control, assesses whether the objectives are con-
sistent with accounting principles that are relevant for that entity and appropriate in
the circumstances.
Example: Specifying Objectives

158 Management and the board of directors of H2O To Go, a bottled water company, set
as the entity’s broad external financial reporting ojective to prepare reliable financial
statements in accordance with US Generally Accepted Accounting Principles (GAAP).

159 Management subsequently specified the suitable financial reporting objectives and sub-
objectives for all significant accounts and activities of H2O To Go’s worldwide business,
including sales, purchasing, and treasury. These objectives and sub-objectives include
accounting policies, financial statement assertions, and qualitative characteristics relat-
ing to its accounts and activities. For instance, management has specified objectives
relating to:
•• Sales existence and completeness financial statement assertions for all sales
transactions recorded during the period7
•• Purchasing completeness and accuracy of financial statement assertions for all

purchasing transactions recorded during the period.
•• Treasury valuation and allocation financial statement assertions for all investments
held and recorded as of period end.
160 Annually, finance management reviews these objectives and sub-objectives for ongoing
relevance and suitability with respect to the company’s accounts and activities. Where
changes are expected to occur—for instance, the adoption of a newly published
accounting standard or guidance or new commercial event or trend—appropriate man-

agement communicates the need to reconsider these objectives to those responsible
for the objective-setting process.
Example: Assessing the Suitability of Specified Objectives

161 The management of Valley Services, a supplier of high-end home theatre systems, set
as the entity’s broad financial reporting objective to prepare reliable financial statements
in accordance with International Financial Reporting Standards (IFRS). This objecitve
was cascaded into various areas of Valley Services business, including sales.
162 Within the sales process, management accepts from one frequent customer, Hall
Electronics, deposits relating to the purchase of several home theatre systems. Valley
Services sets aside the theatre systems in its inventory until Hall Electonics requests
delivery, usually within thirty days. Valley Service must either refund to Hall Electonics
the cash or provide a relacement home theatre system if a system is damaged or lost
prior to delivery.
163 Management had previously established a policy whereby revenue was recognized
upon payment for goods, regardless of whether the goods were delivered. In assessing
the suitabliy of the objectives specified for financial reporting, the controller, Alex Rob-
ertson, determined that this policy may not be in accordance with IFRS. Consequently,
he requested senior managment to review this policy in conjuntion with the objective-
setting process. In addtion, he also advised the internal audit group, which then moni-
tored the resolution of this matter.
7 For purposes of this example, not all relevant financial statement assertions have been included.

Approach: Assessing Materiality

C
omplies with Applicable Accounting 164 Management considers materiality in relation to its objecitves, considering both quanti-
Standards tative and qualitative factors. In conducting this assesment, management may consider
• Considers Materiality factors such as:
Reflects Entity Activities •• Users of the financial statements (i.e., creditors, stockholders, suppliers, employ-
ees, customers, regulators)
•• Size of financial statement elements (i.e., current assets, current liabilities,

total assets, total revenues, net income) and financial statement measures (i.e.,
financial position, financial performance, and cash flows) Uniqueness of the
transaction(s)Difficulty in valuing the balance or specific transactions
•• Trends (i.e., earnings, revenues, cash flows)
Example: Assessing Materiality for a Private Company

Financial Statement
165 The management of Bottomer Holdings, a private owner and renter of residential apart-
ments, recenty installed coin-operated laundry facilities in several of its buildings. A

contractor installed and maintains the machines and will be paid a monthly amount plus
a percentage of revenue earned through laundry services.
166 Looking at this new source of potential revenue relative to the income statement, Bot-
tomer Holdings considered the effect on its total revenues and net income and has now
concluded that the laundry revenue is expected to generate $150,000 to $200,000 of
revenue per year.
167 Management has considered the overall materiality of this account using the quantita-
tive measure of $500,000. Management also considered other qualtitative factors and
determined that this new source of income would:
•• Not change a loss into income—the company has been profitable over the past
five years.
•• Not impact compliance with loan covenants and other contractual agreements—
none of the mortgages on the buildings would require changes in loan repayment
rates based on higher income levels.
•• Not impact management’s compensation, including on-site property management

staff—the additional income would have an insignificant impact on the manage-
ment bonus plan.
168 Based on the assessment, management has concluded that the new source of
income is not material to the overall financial statement presentation. Accordingly,
in specifying its external reporting objectives, management has incorporated this
new source of revenue into its overall revenue objectives as determined by Gener-
ally Accepted Accounting Principles but has not set out new, unique objectives for
laundry-related revenue.

Approach: Reviewing and Updating Understanding of

Applicable Standards
169 Management reviews publications from professional bodies for updates in accounting • C
omplies with Applicable Accounting
pronouncements relevant to the business. Periodically, management presents to the Standards
audit committee an analysis of changes released or emerging issues that may signifi- Considers Materiality
cantly impact financial reporting and notes any significant differences from accounting
Reflects Entity Activities
policies of similar entities. For entities that have multiple reporting obligations, such as
statutory reporting in international locations, management assesses the requirements
relative to the respective divisions or operating units.
Example: Reviewing Financial Accounting Policies

170 Celia Mendez is the controller of a $100 million biotechnology company. She reviews its
accounting principles by considering:
•• Policies selected that are acceptable according to the applicable standards

(US GAAP)
•• Situations where multiple acceptable alternatives are available and the rationale
for selecting one policy over another

•• Differences in its accounting policies from those of its peers
171 Management discusses significant accounting policies with the audit committee on an
annual basis.
Example: Reviewing and Updating Understanding of

Applicable Standards
172 The management of Middle Ocean Inc., an $800 million industrial products company,
regularly reviews the publications from professional bodies for updates in accounting
pronouncements relevant to its business. The controller, Sandy Wong, and the CFO,
Fred Jazbowski, also subscribe to and review periodic email updates on standards
that may be of interest. Each quarter Ms. Wong presents to the company’s audit and
disclosure committees, which consist of key management members, her analysis of any
changes that will immediately impact financial reporting, and any emerging issues that
may impact financial reporting in the future. As part of her standard procedures and
before any change is implemented, Ms. Wong also communicates to these two com-
mittees what impact any updated or new standard will have on the company’s financial
statements, systems, and processes.
Example: Reviewing and Updating Statutory

Reporting Requirements
173 Fred DeQuincy is the local controller of an international subsidiary of a multi-billion-
dollar consumer products company. In his annual reviews of the accounting principles
used for statutory reporting, Mr. DeQuincy considers the following:
•• Consistency with the company’s consolidated accounting standards
•• Required differences as a result of the adherence to different standards

•• Where differences are required, the various alternatives that are available and the
rationale for selecting one policy over another
•• Where differences are required, identifying the policies selected by other compa-
nies within an identified peer group
174 Once he has completed his review, Mr. DeQuincy communicates the differences and the
rationale for selection to the corporate controller.
Approach: Considering the Range of Entity Activities

C
omplies with Applicable Accounting 175 Management, with the oversight of the audit committee, considers the range of the
Standards
entity’s activities to assess whether all material activities are appropriately captured in
Considers Materiality the financial statements. Management considers whether the presentation and disclo-
• Reflects Entity Activities sure of the financial statements enable the intended users to understand these material
transactions and events.
Example: Considering the Range of Assessment Activities

176 Build Free Co. produces large-building products. The management of Build Free
reviews its financial statements on a quarterly basis. The purpose is twofold:
•• To ensure all significant activities are included
•• To analyze its various business units for new and discontinued product develop-
ments and changes in the company’s markets, ensuring that they are conveyed
appropriately in the financial statements
177 In addition, the audit committee discusses with management how any significant activi-
ties that it is aware of will be included in the financial statements.

Risk Assessment | Identifies and Analyzes Risks
Identifies and Analyzes Risks

Principle 7. The organization identifies risks to the
achievement of its objectives across the entity and
analyzes risks as a basis for determining how the risks
should be managed.
Points of Focus
•• Includes Entity, Subsidiary, Division, Operating Unit, and Functional Levels—

The organization identifies and assesses risks at the entity, subsidiary, division,
operating unit, and functional levels relevant to the achievement of objectives.
•• Analyzes Internal and External Factors—Risk identification considers both inter-

nal and external factors and their impact on the achievement of objectives.

•• Involves Appropriate Levels of Management—The organization puts into
place effective risk assessment mechanisms that involve appropriate levels
of management.
•• Estimates Significance of Risks Identified—Identified risks are analyzed through

a process that includes estimating the potential significance of the risk.
•• Determines How to Respond to Risks—Risk assessment includes considering

how the risk should be managed and whether to accept, avoid, reduce, or share
the risk.

Approach: Applying a Risk Identification Process

• Includes Entity, Division, Operating Unit, 179 Management includes a risk identification process that identifies risks of material
and Functional Levels misstatement and the likelihood of occurrence of the risks to relevant financial state-
Analyzes Internal and External Factors ment assertions for each significant account and disclosure. In preparing this analysis,
• Involves Appropriate Levels of Management
management considers the business processes and business units supporting financial
statement accounts and disclosures. The process of identifying the supporting business
Estimates Significance of Risks Identified
units includes discussions with each business unit or process leader. It also includes
Determines How to Respond to Risks identifying the information technology systems that support those business processes
that are relevant to the external financial reporting objectives.
Example: Analyzing Risk across Functions

180 Lionel Tetrault is the CFO of Shark Tank Co., a firearms manufacturer. He convenes a
working session of the department heads of marketing, production, information tech-
nology, human resources, and administration to perform a risk analysis by functional
department. Risks are rated from 1 (least risk) to 5 (most risk) based on potential impact

on financial reporting and likelihood of occurrence. After the discussion sessions, the
participants document the results in a table that outlines each specific risk together with
the rating and factors contributing to the rating.
181 For example, the risk of material misstatement related to the accuracy and valid-
ity of revenue recognition was rated as 5 (high). Factors contributing to the risk
rating included:
•• Complexity of rules for revenue recognition
•• Knowledge level of people responsible for recording sales transactions
•• Complexity of promotion and discount transactions
•• Aggressive sales targets
•• Incentive and bonus structure
•• Supporting systems limitations
Approach: Assessing Risks to Significant Financial

Statement Accounts
Includes Entity, Division, Operating Unit, 182 Management identifies risks to the achievement of financial reporting objectives by
and Functional Levels considering risk factors related to each significant financial statement account and the
• Analyzes Internal and External Factors associated financial statement assertions. The process of identifying and analyzing risk
Involves Appropriate Levels of Management considers both quantitative and qualitative factors, including the following factors:
• Estimates Significance of Risks Identified •• Impact on Financial Statement Accounts—The potential impact on financial
Determines How to Respond to Risks reporting objectives is measured quantitatively. Each account is assessed in rela-
tion to its respective category, such as total assets or revenues. Management also
qualitatively assesses the potential for certain accounts to be understated. Based
on the quantitative and qualitative characteristics, accounts are categorized as

high, medium, and low, based on their impact on the financial statements. Where
risks vary by sub-account, management considers risk at that level.
•• Account Characteristics—Management considers internal factors such as

volume of transactions through an account, judgment required, and complexity
of accounting principles. Management also considers external factors such as
economic, competitive, and industry conditions; the regulatory and political envi-
ronment; any new regulations affecting the account; and changes in technology,
supply sources, customer demands, or creditor requirements.
•• Business Process Characteristics—Management identifies business processes

that generate transactions in each of the financial statement accounts, consider-
ing factors such as complexity of the process, centralization versus decentraliza-
tion, IT systems supporting the process, changes made or new processes added,
and interaction with external parties such as vendors, creditors, shareholders, or
customers.
•• Fraud Risk—For susceptible accounts, management assesses the risk of mis-

statements due to fraud.8
•• Entity-Wide Factors—Management considers internal entity-wide factors such

as the nature of the company’s activities, employees’ access to assets, number
and quality of personnel and levels of training provided, changes in informa-
tion systems, and organizational changes (e.g., changes in senior personnel or
responsibilities). These factors are considered in relation to their effect on account
characteristics, business process characteristics, and fraud risk.
Example: Assessing Risks to Significant Financial

Statement Accounts
183 The management of Bachmann Tools, a hand tool importer, manufacturer, and distribu-
tor, identifies risks to the achievement of financial reporting objectives by considering
risk factors related to each significant financial statement account and disclosure item.
The criteria used for assessing risk are similar to those shown above in Approach:
Assessing Risks to Significant Financial Statement Accounts. Management also links
each account balance to financial statement assertions.
184 The resulting risk assessment is illustrated below.

*Author’s Note: Additional detail underlying the risk assessment would typically be present supporting this
analysis. For purposes of this example the summary of the assessment is provided.
8 As noted in Principle 8, identifying and analyzing fraud risks are integral parts of the risk
assessment process.

Risk Assessment Matrix 1.

Risk Identification and Analysis by Account and Disclosure 9
Financial Statement As % of Impact Account Business Fraud Entity- Overall Significant Assertions6
Account/ Disclosure Total on F/S Charac Process Risk wide Rating
teristics Charac Factors
E C V/A R&O P&D
teristics
BALANCE SHEET
Draftfor
forDiscussion
Discussion
Assets
Draft
Cash & Cash 6% M H M H M H P P P P
Equivalents
Accounts Receivable 30% H H H H L H P P P P
Prepaid Expenses 4% L M L L L L P
Inventory 35% H M M M L M P P P P P
Property & Equipment 15% H L L L L L P P P P
Intangible Assets 10% H M M M M M P P P P
Total Assets 100%
9 Existence, Completeness, Valuation or Allocation, Rights and Obligations, and Presentation and Disclosure

E C V/A R&O P&D
teristics
Liabilities
Accounts Payable 25% H H L M L M P P P P
Accrued Expenses 15% H M M H L H P P P P P
Warranty 15% H M M M L M P P P P P

Long-Term Debt 10% H L L L L M P P P P P
Total Liabilities 65%
Shareholders’
Equity
Common Stock 5% M M M L L L P P P P
Retained Earnings 30% H L L L L M P P P
Total Liabilities and 100%

Equity

Risk Assessment Matrix 1.

Risk Identification and Analysis by Account and Disclosure
E C V/A R&O P&D
teristics
Income Statement
Revenues

Product Sales 85% H H H H M H P P P P
Repair Services 15% H H M M M H P P P P
Total Revenue 100%
Cost of Goods 40% H H H H M H P P P P
Operating
Expenses
Compensation & 28% H H H M L M P P P

Related Benefits
Marketing & Selling 7% M M L L L M P P P

Expenses
G&A Expense 3% L M L L L L P P P
Depreciation & 2% L M M L L L P P P
Amortization
Total Operating 40%

Expenses

E C V/A R&O P&D
teristics
Other Income/
Expense
Interest Income/ 5% L L M L L M P P P
(Expense)
Income Taxes Expense 5% L M H M L H P P P

Net income 10%
Total, as percent of 100%

Revenue

Example: Using Risk Ratings

185 The management of Sure Health Care has developed a rating system to show general
measures and trends of relevant risks. It now uses the ratings to determine which
processes require more in-depth attention. The relevance of the financial reporting
assertions for the related accounts is also considered. Management reviews the identi-
fied risks and provides a rating based on the inherent and residual risks to the entity; it
updates these ratings periodically.
186 The information technology managers of Sure Health Care meet with finance personnel
every month to discuss process, changes, and projects in each functional area relat-
ing to financial reporting. The meetings are used to update team members and discuss
issues or changes to the processes. Additionally, management meets with outside legal
counsel every quarter to discuss the effects of any external regulatory changes that may
impact financial reporting.
187 The ratings are as follows:
•• High—Critical processes that require more in-depth documentation, including a

matrix to describe identified risks and controls that mitigate these risks. Process

maps and narratives are also developed to describe the flow of transactions and
to identify control points. Controls are identified as preventive or detective, and
manual or computer-based. Policies and procedures that guide employees in
applying control activities are identified.
•• Medium—Processes for which management prepares process documentation

that includes a matrix to describe identified risks and controls that mitigate the
risks. Process maps and narratives are developed where applicable at a high
level. Policies and procedures are identified, but in less formal, summary form.
•• Low—Processes that require minimal process documentation, which may address

only key policies and procedures and applicable controls.
Approach: Meeting with Entity Personnel

• Includes Entity, Division, Operating Unit, 188 Key finance personnel meet regularly with:
and Functional Levels
•• Executive management to identify initiatives, commitments, and activities affect-
Analyzes Internal and External Factors
ing risks to financial reporting
• Involves Appropriate Levels of Management
•• Information technology personnel to monitor changes in information technology
that may affect risks related to financial reporting
Determines How to Respond to Risks
•• Human resources staff to identify and assess how changes in personnel and
movement in positions may affect competencies needed for internal control over
external financial reporting
•• Legal counsel to stay abreast of legal and regulatory changes
•• Other members of the entity as areas of focus are identified by

executive management.

Example: Analyzing Risk for Information Technology

189 McFayden Inc. is a spirits distillation and distribution company with a dedicated infor-
mation technology department. Risk assessment is driven by the number and complex-
ity of applications that support the financial reporting process. This approach helps
the company establish which information systems management relies on for financial
reporting. Prior to implementing new systems, and whenever significant changes to
existing systems are planned, McFayden Inc. takes the following steps:
•• IT personnel meet with the business process owners to consider IT process–

related risks. At these meetings, IT learn how application data are used in the
financial reporting process, identify risks of inaccurate or incomplete processing,
and consider existing general computer controls in determining whether computer
application controls or related user controls need to be enhanced.
•• Relevant IT staff, along with business process owners, map the related applica-
tions to the operating systems, databases, and supporting IT processes, and
consider inherent risks and what improvements are needed.
•• IT personnel with relevant experience review opportunities to automate manual

controls to improve efficiency.

•• IT discusses activities with finance personnel.
Approach: Assessing the Likelihood and Significance of

Identified Risks
190 Management analyzes the significance of identified risks based on the likelihood of the Includes Entity, Division, Operating Unit,
risk occurring and the inherent risk of a material misstatement to the entity’s external and Functional Levels
financial reporting objectives. Based on the outcomes of the analysis, management Analyzes Internal and External Factors
determines how to manage the risks to a tolerable level. Involves Appropriate Levels of Management
• Estimates Significance of Risks Identified
Example: Identifying and Responding to Risk • Determines How to Respond to Risks
191 A social service organization with significant amounts of federal funding and operations
in several foreign countries prepares an annual risk assessment of its financial reporting
processes in each country. Risk factors considered include the following:
•• Size of program and growth/downsizing
•• Nature of funding in the country and types of program (federal or local)
•• Nature of transactions
•• Quality and timeliness of reporting (program and accounting)
•• Quality of management and turnover (finance and program)
•• Results of prior year’s internal, external, and statutory audits
•• Perception of country’s political, social, and economic environment
•• Oversight provided by funding sources in the countries

192 The risk assessment is prepared by the CFO, Gerald Timewell, and the COO, Inga
Karran, with input from many others within the organization. The resulting assessment,
for financial reporting purposes, considers the above risk factors in determining the sig-
nificance of risks of material misstatement related to the financial reporting assertions.
For instance, management increased the assessed risk relating to existence of federal
funding revenue from moderate to high after considering that there is:
•• Uncertainty over the ongoing viability of funding programs in some

foreign countries
•• Irregular timing of funding payments in some foreign countries
•• Weaknesses noted in a recent internal audit review
193 Based on this risk assessment, Mr. Timewell and Ms. Karran develop preliminary
positions on the risk response. These determinations are key inputs into determining
required control activities.
Example: Using Benchmark Data to Assess Significance and Re-

sponse to Risk

194 A pet food retailer, Best Bits, uses benchmarking techniques to assess losses in physi-
cal inventory from theft. The “shrink percentage” calculated is defined as the value of
lost physical inventory divided by net sales. The amount of physical loss is determined
through a physical inventory count process.
195 The company is currently examining ways to enhance its risk response decisions to
reduce the significance of the risk by altering either likelihood or impact. Given the com-
pany’s current level of losses (1.6%), accepting the risk would not be acceptable, and
management elects to implement control activities that reduce the likelihood of losses
(operations objectives) and implements controls to detect losses sooner (to support its
financial reporting objectives).
196 Best Bits management also notes the level of losses other companies incur due to
shrinkage. The figure below shows the shrinkage for several other similar companies
within a benchmark group. Best Bits’ losses are noted underneath for comparison.
3.5
3.0
2.5 Quartile 4 1.80%-3.50%

Quartile 3 1.30%-1.80%
Percentage
2.0
1.5 1.6 Quartile 2 0.88%-1.30%
1.0 Quartile 1 0.33%-0.88%
0.5
Best Bits Average Low Median High
0.0
Shrinkage 1.60% 0.33% 1.30% 3.50%

197 Using the data provided in this analysis, management believes that a loss rate target of
1.3% is suitable for the company (e.g., top of quartile 2) and additional control activities
are developed within the receiving and shipping process (as part of the Control Activi-
ties component). Further, management accelerated the frequency of physical inventory
counts to quarterly to improve the timeliness of financial reporting.
Approach: Considering Internal and External Factors

198 Management considers external factors that may impact the ability to achieve financial Includes Entity, Division, Operating Unit,
reporting objectives, such as: and Functional Levels
• Analyzes Internal and External Factors
•• Economic changes
Involves Appropriate Levels of Management
•• Natural or human-caused catastrophes or environmental changes
• Estimates Significance of Risks Identified
•• New standards Determines How to Respond to Risks
•• Changes to laws and regulations
•• Changing customer demands

•• Technological developments
199 Management considers internal factors that may impact the entity’s ability to achieve its
financial reporting objectives, such as:
•• Use of capital resource determinations
•• Change in management responsibilities
•• Personnel hiring and training considerations
•• Employee accessibility to assets
•• Internal information technology changes
200 Where these factors are noted, management also considers—in conjunction with the
Information and Communication principles—whether some form of internal and/or exter-
nal communications are needed.
Example: Analyzing Risks from External Factors

201 As CEO of global technology company World Find, Derek Burtnyk makes time for a
quarterly discussion on emerging financial accounting standards with each of the
company’s regional controllers. These discussions focus on potential and announced
changes occurring within each jurisdiction, and whether these would require changes to
the company’s technology systems.
202 Based on the insights gathered from those discussions, Mr. Burtnyk provides feed-
back to the various department leaders of World Find. In turn, the department heads
use this information to identify additional information requirements and potential
technology changes.

203 In one instance, World Find determined that the accounting requirements for a new
value-added tax in one jurisdiction could impact operations in that jurisdiction as well
as two other jurisdictions that interact with it. Based on this assessment, manage-
ment commenced a project to further refine the assessment of the risks related to the
accounting of the new commodity tax, which then served as a basis for how to respond
to those specific risks.
Example: Considering Changes in Information Systems

204 Paula Wing is the CEO of a specialty resin company with operations in nine countries.
She continually reviews risks to the company by leading monthly staff meetings where
she asks senior managers to comment on any new risks identified, including those
related to changes in systems, personnel processes, or activities. Ms. Wong discusses
any insights she has on risks facing the company, including those that impact finan-
cial reporting. As a team, Ms. Wong and the senior managers develop the needed
risk responses.

Approach: Evaluating Risk Responses
Includes Entity, Division, Operating Unit, 205 Management considers a variety of risk responses—avoid, accept, reduce, share—
and Functional Levels when evaluating whether risks are reduced to an acceptable level. In this process,
Analyzes Internal and External Factors management may consider unique risks related to financial reporting or a combination
Involves Appropriate Levels of Management of risks. Management may also consider how risk responses impacting the five compo-
nents of internal control interact to reduce risk to an acceptable level.
• Determines How to Respond to Risks
Example: Considering Risk Response in a Revenue Process
206 Bailey Campbell, the controller for Center Bay Packaging, assesses the risk relating to
completeness of revenue. The company has grown over the past five years and now has
annual revenues in excess of $50 million. Currently, Center Bay relies on a paper-based
bill-of-lading system. Revenue is recognized when the bill of lading is signed by the
customer as evidence of receipt of the goods.
207 Ms. Campbell has noted instances in the past year where shipping documentation was
not provided to the finance department in a timely manner, sometimes as late as two
weeks after the shipment was completed. These delays have result in an understate-
ment of revenue. Ms. Campbell has determined that the risk related to revenue com-
pleteness needs to be further reduced, and so she has decided to implement a bar-
code scanner shipping system to track and capture shipments and revenue.

Risk Assessment | Assesses Fraud Risk
Assesses Fraud Risk

Principle 8. The organization considers the potential for
fraud in assessing risks to the achievement of objectives.
Points of Focus
•• Considers Various Types of Fraud—The assessment of fraud considers fraudu-

lent reporting, possible loss of assets, and corruption resulting from the various
ways that fraud and misconduct can occur.
•• Assesses Incentive and Pressures—The assessment of fraud risk considers

incentives and pressures.
•• Assesses Opportunities—The assessment of fraud risk considers opportunities

for unauthorized acquisition, use, or disposal of assets, altering of the entity’s

reporting records, or to committing other inappropriate acts.
•• Assesses Attitudes and Rationalizations—The assessment of fraud risk

considers how management and other personnel might engage in or justify
inappropriate actions.
Approach: Conducting Fraud Risk Assessments

Management conducts a comprehensive fraud risk assessment to identify the various • Considers Various Types of Fraud
209
ways that fraud and misconduct can occur, considering: Assesses Incentive and Pressures
• Assesses Opportunities
•• The degree of estimates and judgments in external financial reporting
• Assesses Attitudes and Rationalizations
•• Methodology for recording and calculating certain accounts (e.g., inventory)
•• Fraud schemes and scenarios that are common to the industry sectors and
markets in which the entity operates
•• Geographic regions where the entity does business
•• Incentives that may motivate fraudulent behavior
•• Nature of automation
•• Unusual or complex transactions subject to significant management influence
•• Last-minute transactions
•• Vulnerability to management override and potential schemes to circumvent exist-

ing control activities

210 From these considerations, management makes an informed assessment of spe-

cific areas where fraud might exist and the likelihood of their occurrence and
potential impact.
Example: Assessing Fraud Risk

211 David Kates, the chief compliance officer at a global retail operation, annually conducts
a fraud risk assessment. In doing so, he interviews management at all the international
locations about fraud issues. He analyzes:
•• Historical fraud activities, including theft of inventory and the processes in place
to identify and record such theft
•• The methodology used for recording and calculating inventory and shrinkage
•• Whistle-blower reports
•• The number of manual entries versus automated entries recorded
•• The number of late entries due to subjective estimates
212 With this information, Mr. Kates forms a preliminary view of the potential fraud activities,

which he discusses with management of each jurisdiction in order to consider implica-
tions and what control activities can reduce the risk of fraud. He also has discussions
with human resources personnel and reviews information in the staff files. He uses his
historical knowledge and staff information to assess the attitude of the local manage-
ment toward the tolerance of fraud and to determine whether local management may
rationalize fraudulent activities, including corruption.
213 After completing his fraud risk assessment, Mr. Kates submits a report to the audit
committee for its consideration in management oversight.
Approach: Considering Approaches to Circumvent or

Override Controls
• Considers Various Types of Fraud 214 In identifying and evaluating the presence of entity-wide controls that address fraud,
Assesses Incentive and Pressures management considers how individuals might circumvent or override controls intended
• Assesses Opportunities to prevent or detect fraud. Entity personnel, including management, may intentionally
override in a number of ways, which may include:
Assesses Attitudes and Rationalizations
•• Recording fictitious business events or transactions
•• Changing the timing of recognition of legitimate transactions (particularly those

recorded close to the end of an accounting period)
•• Establishing or reversing reserves to manipulate results
•• Altering records and terms related to significant or unusual transactions

Risk Assessment | Assesses Fraud Risk
Example: Maintaining Oversight

215 The audit committee of Marker’s Medical Supply Company takes the issue of man-
agement override of controls very seriously. Consequently, every quarter the com-
mittee reviews the fraud risk assessment process. In doing so, the members of the
audit committee:
•• Maintain an appropriate level of skepticism
•• Discuss management’s assessment of fraud risks
•• Use the code of conduct to assess financial reporting culture
•• Ensure the entity has a robust whistle-blower program
•• Develop a broad information and feedback network
216 In addition, the audit committee asks the chief audit executive about:
•• What fraud risks are being monitored by the internal audit team on a periodic or
regular basis
•• What specific procedures internal audit performs to address management over-

ride of internal controls
•• Whether anything has occurred that would lead internal audit to change its
assessment of the risk of management override of internal controls
217 With this information in hand, the audit committee discusses with the full board and
senior management any concerns that need added management focus.
Approach: Considering Fraud Risk in the Internal Audit Plan

218 • Considers Various Types of Fraud
The chief audit executive incorporates results of the fraud risk assessment into the inter-
nal audit plan. He or she reviews and confirms that the internal audit plan addresses Assesses Incentive and Pressures
relevant risks. Assesses Opportunities
Example: Analyzing Fraud Risk by the Internal Audit Department
219 The internal audit department at Maxwell’s, a 24,000-employee consumer products
company with locations in several countries, works with the business unit leaders to
identify potential fraud risks. These risks are then prioritized by management and inter-
nal audit, and categorized into various components, including risks for inventory theft,
manipulation of financial statements through accounting estimates, and other potential
means of overriding controls. Management then identifies procedures to reduce these
fraud risks, and internal audit considers these fraud risks and controls when planning its
audit projects. Internal audit may modify the timing and depth of its procedures based
on the assessed fraud risks and management’s planned responses.
220 The local internal audit representatives for Maxwell’s report any identified fraud risks
and internal audit’s planned approach to the chief audit executive, who reviews and
communicates such findings to the company’s audit committee.

Approach: Using Information Technology Tools

• Considers Various Types of Fraud 221 Management uses, where practical, information technology tools to identify and
Assesses Incentive and Pressures manage fraud risk. These include security systems, automated fraud detection tools,
monitoring tools, and incident tracking systems.
Assesses Opportunities
Example: Reporting and Investigating Fraud
222 The management of Swift Co., a 160-employee consumer finance company, established
a standardized process for reporting and investigating suspected fraud. The company
now has a whistle-blower hotline through which employees can report alleged instances
of fraud.
223 Whenever a report is made, the external vendor that manages the hotline initiates an
investigation conducted by a three-person team, which includes Swift Co.’s chief audit
executive, Arthur Suzuki. Using a centralized case management system, Mr. Suzuki is
able to generate quarterly reports that he provides to senior management and the audit
committee. As part of its oversight role, the audit committee meets privately with the
chief audit executive and reviews the provided reports.

Considers Various Types of Fraud 224
Approach: Reviewing Incentives and Pressures Related to Compen-
sation Programs.
Management considers how personnel may rationalize behavior regarding evaluations,
• Assesses Incentive and Pressures compensation, or employment. The board and management review the entity’s com-
pensation programs and performance evaluation process to identify potential incentives
Assesses Opportunities
and pressures for employees to commit fraud. This review considers how meeting, or
not meeting, financial reporting targets potentially impacts an individual’s evaluation,
compensation, and continued employment.
Example: Analyzing Compensation Structure

225 The compensation committee of the board of directors of Schmidt Auto, a global auto-
motive supplier, annually reviews the executive officer compensation packages with the
audit committee, chairperson, and chief auditor. To determine the incentives to manage-
ment, the following items are discussed:
•• Thresholds for significant changes in compensation
•• Mix of total compensation versus incentive compensation
•• Structure of compensation compared with industry peers
•• Mix of long-term compensation compared with short-term incentives
226 After these discussions for Schmidt Auto’s last fiscal year, the board determined that
the CFO’s incentive compensation, 80% of which was based on the current year’s net
revenue, was too high and focused too much on the short term. The compensation
committee subsequently reduced the incentive compensation, with 40% derived from
current year’s net revenue.

Risk Assessment | Identifies and Analyzes Significant Change
Identifies and Analyzes Significant Change

Principle 9. The organization identifies and assesses
changes that could significantly impact the system of
internal control.
Points of Focus
•• Assesses Changes in the External Environment—The risk identification process

considers changes to the regulatory, economic, and physical environment in
which the entity operates.
•• Assesses Changes in the Business Model—The organization considers the

potential impacts of new business lines, dramatically altered compositions of
existing business lines, acquired or divested business operations on the system of
internal control, rapid growth, changing reliance on foreign geographies, and new

technologies.
•• Assesses Changes in Leadership–The organization considers changes in

management and respective attitudes and philosophies on the system of
internal control.
Approach: Assessing Change in the External Environment

228 Management develops approaches for observing changes in the external market and • C
onsiders Change in the External
assessing the potential impact on the entity’s operations and financial reporting. This Environment
may include reviewing the following: Assesses Changes to the Business Model
Assesses Changes in Leadership
•• Websites and social media
•• Website tracking tools
•• Newspaper clipping services
•• Search engines
•• Trade publications and trade shows
•• Conferences
•• Professional organizations

Example: Reacting to Significant Change Caused by

External Factors
229 Last year, Clear Blue Auto Manufacturing became aware of a hurricane approaching one
of its off-shore operations that had the potential to cause significant supply disruptions.
In response, the company immediately established an internal working team to assess
the risks of such a disruption to its manufacturing capabilities, and the risks of its own
affected facilities to its overall manufacturing footprint. All significant suppliers were
contacted and asked to assess the impact the hurricane might have on their production
abilities. A detailed list of parts that might be delayed in production and shipping was
created, and then alternative suppliers were identified. Where no alternative suppliers
could be found, management identified a prioritization list of which manufacturing loca-
tion should receive the limited number of parts as they became available.
230 During this process, the accounting and finance departments of Clear Blue Auto
determined how plant shutdowns would affect the financial statements. This included
potential penalties contained within various sales contracts, possible obsolescence of
parts required for a particular model year being phased out and greater impacts from
extended delays in supply of parts. They also evaluated what insurance coverage was

available to mitigate potential losses. These teams were also responsible for identifying
incremental risks from required system and process changes when working with the
company’s suppliers.
231 The potential impact of this hurricane was updated and communicated to the compa-
ny’s board of directors later that day.
Approach: Conducting Risk Assessments Relating to

Significant Change
C
onsiders Change in the External 232 Following a decision to pursue a new business strategy or significantly change the
Environment current strategy, management conducts a detailed risk assessment to consider how the
• Assesses Changes to the Business Model changes might impact the achievement of all objectives set across the entity.
Assesses Changes in Leadership
Example: Updating Risk Assessment for a New CEO
233 Geoffrey McPherson was recently appointed the CEO of Garner’s Heating, a manu-
facturer of heating and air conditioning components. One of his first tasks in his new
position was to establish a 100-day plan to assess the overall business and determine
where changes were required. To initiate the process, Mr. McPherson called a meeting
with the leaders of all key functional areas to talk about risk.
234 Over the next 100 days, Mr. McPherson will be holding individual meetings with each
functional team to discuss their current objectives, how those objectives might be
changed, and how those changes would impact the assessment of risks to reliable
financial reporting. He expects that some at Garner’s Heating will be surprised with his
proposed changes to policies, which have been largely unchanged for several years.
This includes the company’s CFO, Ruth Koziak, who is responsible for analyzing the
change in strategy and the implications to financial reporting.

Risk Assessment | Identifies and Analyzes Significant Change
235 At the end of the 100 days, Mr. McPherson intends to reconvene the larger group to
discuss how the company should change, and the incremental risks (including financial
reporting) that may come with the change. It will then be up to Ms. Koziak and the chief
audit executive to consider the implications of the company’s new vision and the effects
it will have on the external financial reporting objectives.
Example: Responding to Significant Change from

International Exposure
236 Consecutive Corp., a multi-billion-dollar technology equipment manufacturer that has
historically focused on sales in the United States, has decided to expand internationally
with both sales and manufacturing. As part of the expansion plans, Consecutive has
assessed several factors:
•• Incremental revenue opportunities
•• Competition in the marketplace
•• Cultural dynamics of the targeted international location
•• Different laws and regulations, including those that would affect the company’s

ability to defend its patents
•• Risk of increased fraud from theft and corruption
237 Each of these factors presents incremental risks to financial reporting and processes
that need to be managed. Therefore, Consecutive’s corporate controller is performing
a risk assessment with the finance teams in the international locations to ensure these
new risks are identified and to help management determine how best to respond.
Example: Responding to Significant Change from an Acquisition

238 Industrial products giant Wilson & Zachary recently acquired another multi-billion-dollar
company. During the due diligence process, the company performed a risk assessment
on the new business to be acquired and also updated its own risk assessment consid-
ering the following items:
•• New markets that will be encountered by the combined company (including differ-
ing financial reporting standards)
•• The ability to assimilate the financial reporting processes of the acquired

company, including the effects on migrating to a combined information technol-
ogy system
•• The ability to achieve the anticipated synergies from the acquisition and whether
these synergies will create incremental risks to financial reporting
239 A project team has been formed for the transition to ensure that all risks are appropri-
ately identified across all business units and functional areas. Any identified risks are
passed on for assessment to senior management, including the company’s chief oper-
ating officer and chief financial officer.

Approach: Considering Change through Succession

C
onsiders Change in the External 240 As part of the overall succession process, management reviews planned changes in
Environment management and leadership positions and the attitudes and values portrayed by the
Assesses Changes to the Business Model incumbents to those positions through interviews with personnel within the entity.
• Assesses Changes in Leadership
Example: Planning for Executive Transition
241 The board of Turnball Insurance annually reviews the transition plans for key executive
leadership in the company. As part of this review, the board discusses with the chief
audit executive the perceived attitudes and values of those individuals who have been
identified as successors. Such considerations may include focusing on attaining profit
expectations versus maintaining effective control, including any concerns about the
potential management override of controls.
242 If the transition for a particular position is expected to occur within the next two years,
representatives of the audit committee interview the candidates to ensure that their
views on internal control are consistent with those expected by the audit committee.
243 The board considers that feedback attained when making any decisions within the

scope of its responsibility. The audit committee communicates its findings to the
CEO and other members of senior management, who ultimately will make decision on
other successors.
Approach: Considering CEO and Senior Executive Changes

C
onsiders Change in the External 244 As part of recruiting for the CEO and other executive team members, the audit commit-
Environment
tee asks candidates to articulate its views on the importance of internal control and how
Assesses Changes to the Business Model it would balance the need for effective control with other pressures for performance and
• Assesses Changes in Leadership cost considerations.
Example: Preparing for a Change in CEO

245 As part of the recent interview process for a new CEO, the board of directors of Mills
and Associates, an industrial products company, asked all candidates their perspec-
tives on risk, risk tolerance, and internal control, including current areas of emphasis.
246 The successful candidate, Jenny Acosta, has a strong background and focus on cost
management and streamlining operations. However she agrees with the audit commit-
tee that this streamlining could result in fewer processes and controls, especially those
viewed to be labor intensive, and that such changes could erode the quality of reporting
and increase certain financial reporting risks.
247 With this in mind, the audit committee has begun to request quarterly updates of
controls that have been removed by management and the potential impact on financial
reporting. In addition, this information is incorporated by the internal audit group into its
internal audit planning process.

Components of Internal Control | Control Activities
4. Control Activities
Chapter Summary
248 Control activities are the actions established through policies and pro-
cedures that help ensure that management’s directives to mitigate risks
to the achievement of objectives are carried out. Control activities are
performed at all levels of the entity, at various stages within business
processes, and over the technology environment. They may be preven-
tive or detective in nature and may encompass a range of manual and
automated activities such as authorizations and approvals, verifications,
reconciliations, and business performance reviews. Segregation of du-
ties is typically built into the selection and development of control activi-

ties. Where segregation of duties is not practical, management selects
and develops alternative control activities.
Principles relating to the Control Activities component
10. The organization selects and develops control activities that

contribute to the mitigation of risks to the achievement of objectives
to acceptable levels.
11. The organization selects and develops general control activities over
technology to support the achievement of objectives.
12. The organization deploys control activities through policies that

establish what is expected and in procedures that put policies
into action.

10. The organization selects and •• Using Matrices, Workshops, or an

develops control activities that Inventory of Control Activities to Iden-
contribute to the mitigation of risks tify Risks and Map Them to Control
to the achievement of objectives to Activities
acceptable levels.
•• Implementing or Monitoring Control
Activities When Outsourcing to a
Third Party
•• Considering the Types of Control

Activities
•• Considering Alternative Control

Activities to the Segregation of Duties
•• Identifying Incompatible Functions
11. The organization selects and devel- •• Using Risk and Control Matrices to
ops general control activities over Document Technology Dependencies

technology to support the achieve-
•• Evaluating End-User Computing
ment of objectives.
•• Implementing or Monitoring Control
Activities when Outsourcing IT Func-
tions to a Third Party
•• Configuring the IT Infrastructure to

Support Restricted Access and Seg-
regation of Duties
•• Configuring IT to Support the Com-

plete and Accurate Processing of
Transactions and Data
•• Administering Security and Access
•• Applying a System Development Life

Cycle over Packaged Software
•• Applying a System Development

Life Cycle over Software Developed
In-House
12. The organization deploys control •• Developing and Documenting Policies

activities through policies that and Procedures
establish what is expected and in
•• Deploying Control Activities through
procedures that put policies into
Business Unit or Functional Leaders
action.
•• Conducting regular and Ad Hoc
Assessments of Control Activities

Control Activities | Selects and Develops Control Activities
Selects and Develops Control Activities

Principle 10. The organization selects and develops
control activities that contribute to the mitigation of risks
to the achievement of objectives to acceptable levels.
Points of Focus
•• Integrates with Risk Assessment—Control activities help ensure that risk

responses that address and mitigate risks are carried out.
•• Considers Entity-Specific Factors—Management considers how the environ-

ment, complexity, nature, and scope of its operations, as well as the specific
characteristics of its organization, affect the selection and development of
control activities.

•• Determines Relevant Business Processes—Management determines which
relevant business processes require control activities.
•• Evaluates a Mix of Control Activity Types—Control activities include a range

and variety of controls and may include a balance of approaches to mitigate
risks, considering both manual and automated controls, and preventive and
detective controls.
•• Considers at What Level Activities Are Applied—Management considers control

activities at various levels in the entity
•• Addresses Segregation of Duties—Management segregates incompatible duties,

and where such segregation is not practical, selects and develops alternative
control activities.

Approach: Using Matrices, Workshops, or an Inventory of Control

Activities to Map Identified Risks to Control Activities
• Integrates with Risk Assessment 250 Once risks have been identified and mapped to relevant financial statements asser-
• Considers Entity Specific Factors tions, management determines relevant business processes and selects and develops
• Determines Relevant Business Processes
control activities to address each risk. Management involves relevant stakeholders to
identify the appropriate control activities. This includes those individuals responsible for
Evaluates a Mix of Control Activity Types
the risks in their areas, finance personnel responsible for financial reporting, and other
C
onsiders at What Level Activities control experts, such as internal auditors or others who have relevant specialized knowl-
are Applied
edge. A centralized group responsible for financial reporting or control activities periodi-
Addresses Segregation of Duties cally reviews the risk control matrices to help ensure that the entity’s financial reporting
risks are being addressed.
251 The selection and development of control activities is achieved through various
methods, and may include the following:
•• Using matrices to map identified risks to controls activities

•• Holding workshops to identify appropriate control activities for each identified risk
•• Using an inventory of control activities, tailoring them as appropriate
252 Management considers the segregation of duties and a mix of transaction control activi-
ties and business process reviews. Management considers using automated controls
whenever the systems in place make it possible. These are supplemented by manual
control activities where automated controls are not available.
Example: Using Workshops to Map Identified Risks to

Control Activities
253 A multi-million-dollar consumer products company, Prescott International, holds a
number of workshops to select and develop appropriate control activities for each iden-
tified risk relating to financial statement assertions for revenue recognition. The meet-
ings are attended by employees from various departments—credit, shipping, billing, and
customer service—who review the list of activities and link them to risks identified in the
company’s risk assessment.
254 After these workshops, Prescott International is able to select and develop poli-
cies and procedures appropriate to its business. The controller reviews the matrix
of control activities and risks in order to identify any potential risks not previously
noted, recommend additional control activities if necessary, and remove unnecessary
control activities.

Example: Using a Matrix to Map Risks to Control Activities

255 A multi-million-dollar manufacturer of sporting goods equipment, Go Rite Sports, devel-
ops a matrix in conjunction with its risk assessment process. The matrix sets out:
•• Financial reporting objectives and relevant assertions
•• Identified risks
•• Risk responses
•• Control activities
256 Matters such as general ledger maintenance, accruals, management estimates and
reserves, period-end close and consolidation procedures, financial statement prepara-
tion, and regulatory filings and disclosures are all considered when building the matrix.
The risks, risk responses, and controls are described in sufficient detail in the matrix to
allow Go Rite’s management and others to evaluate whether, if implemented and
operating as intended, these actions can sufficiently mitigate the financial reporting
risks. As part of this evaluation, management reviews the type of control activity (e.g.,
Top-Down Risk Assessment
preventive versus detective, manual versus automated) to determine if the mix is
appropriate. The following illustration is an excerpt of one of Go Rite’s risk and control

matrices with accompanying flowchart.
Ordering Invoicing
Purchase Order Vendor Invoice
Purchasing Dept. AP System Purchasing Dept. Buyer Accounting Dept.

Initiate Edit and Generate Approve AP Sub
Input Invoice Ledger
Purchase Order Validation Check Purchase Order Purchase Order
1.1.1 1.1.2 1.1.3 1.1.4 1.2.1
Accounting Dept.
Purchase Order Approved Goods Receipt
Vendor Price Vendor Price 3-Way Match
Purchase Order Notice (GRN)
Master Master Master Master 1.2.2
Accounting Dept.
General
Record Invoice Ledger
1.2.3

Control Financial F/S Control Frequency Control Description Manual/ Preventive/ Infor-
Risk(s) Asser- Level of Control Automated/ Detective mation
tions IT Depen- Processing
(note 1) dent Manual Objective
(note 2)
A Orders V Transaction Multiple During the PO creation the system Automated Preventive A, V
are not Level times per performs edit checks (autopopulated
accurate day fields, format checks and use of drop
down lists) of the relevant data fields
and auto-populates vendor and item
details using the vendor and item
master file respectively. The system
populates price in the purchase order
from the approved master file based on
the product entered.
B Orders E/O Transaction Multiple The system blocks purchase orders not Automated Preventive A,V
are not Level times per using an approved vendor and items
valid day from the related master file.
C Order V Transaction Multiple Purchase order price outside those Manual Preventive A,V

process- Level times per specified in the approved master file
ing is day must be approved in the system by
inaccu- authorized personnel for processing to
rate continue.
D Orders V, E/O Transaction Multiple Purchase Orders must be approved by Manual Preventive A,V
are inac- Level times per the appropriate buyer who is in charge
curate or day of signing the Purchase Order.
valid
E Invoice "V, E/O, Transaction Multiple The system performs a three-way Automated Preventive A,V
process- R&O Level times per match by comparing pertinent data
ing is day (e.g. price, quantity, etc.) between the
inac- purchase order, invoice and receiving
curate or document. As part of the three-way
not valid match the mathematical accuracy
of the incoming invoice. further is
checked. Processing is blocked when
differences exceeding a predetermined
threshold are noted. Invoices with
differences are flagged for further
investigation.
F AP C, E/O Business Monthly As part of the Period end close activi- IT Dependent Detective C,V
accrual is Per- ties, a review of the services/goods Manual
incom- foramnce received not invoiced report (GRNI) is
plete or Review performed by the accounting depart-
invalid ment personnel. This review includes
analysis of account details and adjust-
ments recorded during the period.
Unusual and/or all aged goods/services
received not invoiced items are investi-
gated and resolved on a timely basis.
Note 1: E/O = Existence / Occurance; C = Completeness; V = Valuation / Allocation; R&O = Rights and Obligations
Note 2: C = Completeness; A = Accuracy; V = Validity

Example: Using an Inventory of Risks and Control Activities

257 Indigo Brewing is a large global beer brewing company. It has created a standard inven-
tory of risk and control activities that it uses as a basis for all its brewing subsidiaries.
It created the inventory by customizing a generic inventory of brewing industry risks
and control activities that it obtained from Risk Reverse Inc. with Indigo entity-specific
considerations. Some of the entity-specific considerations include:
•• Standard company-wide configurations for its enterprise resource planning

(ERP) system
•• Business performance reviews required of every business unit by

corporate finance
•• A baseline set of control activities to comply with Sarbanes-Oxley requirements
258 Following Indigo’s recent acquisition of a foreign entity in China, another brewery, the
management used the standard risk and control inventory to develop and select the
necessary control activities. It customized this list to suit the newly merged company,
giving the functional leaders responsibility for risks and control activities in their
specific areas.

259
Approach: Implementing or Assessing Control Activities when Out-
sourcing to a Third Party
• Integrates with Risk Assessment
The organization outsources some of its operations to a third party, which may or may
not issue a “report on controls at a service organization” following an appropriate local • Considers Entity Specific Factors
or international standard. Management obtains an understanding of the service organi- • Determines Relevant Business Processes
zation’s activities and whether those activities impact significant classes of transactions,
accounts, or disclosures in the company’s reporting process. In determining the sig-
C
onsiders at What Level Activities
nificance of the service organization’s processes to the financial statements, the entity
are Applied
considers the following factors:
Addresses Segregation of Duties
•• The significance of the transactions or information processed by the service orga-
nization to the entity’s financial statements
•• The risk of material misstatement associated with the assertions affected by the
processes of the service organization, including whether the activities involve
assets that are susceptible to loss or misappropriation
•• The nature and complexity of the services provided by the service organization
and whether they are highly standardized and used extensively by many organiza-
tions or unique and used only by a few
•• The extent to which the entity’s processes and control activities interact with
those of the service organization
•• The entity’s control activities that are applied to the transactions affected by the
service organization’s activities
•• The terms of the contract between the entity and the service organization, and the
degree to which authority is delegated to the service organization

260 If management determines that the service organization’s processes are significant to
internal control over external financial reporting, then it:
•• Identifies the specific control activities performed by the service organization that
are relevant to financial statement assertions, and/or
•• Selects and develops control activities internally over the activities performed by
the service organization.
261 If a report on controls at a service organization is available, management can use it

to determine what financially significant processes are covered, whether appropriate
control activities are in place, and what control activities are required in its own organi-
zation to address external financial reporting risks.
262 If an appropriate report does not exist, management can use the entity’s own resources,
such as internal audit, to review the control activities and ensure that any external finan-
cial reporting risks are mitigated by the combination of its own control activities and
those of the service organization.
Example: Obtaining a Report on Controls at a Service Organization

from a Service Payroll Provider
263 Green Grow Now is a 250-person company that packages and distributes organic
produce. It uses a third-party service, Jennssen Inc., to process payroll, which is con-
sidered significant to the company’s financial reporting because employee costs are a
large part of Green Grow Now’s expenses.
264 Jennssen Inc. engages a service auditor to audit its control activities over transac-
tion initiation, processing, and recording, and to issue an SSAE 16 (SOC1)10 report on
controls. When Green Grow Now obtains the report, it assesses whether the described
control objectives and control activities performed by Jennssen impact internal control
over external financial reporting related to the existence, completeness, and valuation of
payroll expense.
265 Green Grow Now considers the test results in the report and whether any exceptions
have been identified. It also considers the period covered by the report and concludes
that it needs additional evidence of the operation of control activities for the period
not covered. The management communicates directly with Jennssen to inquire about
any changes to its processes; Jennssen confirms in writing that no changes have
been made.
266 Based on this information, Green Grown Now concludes that no further action is
needed. It also reviews the control activities that it is expected to have in place in its
own organization (as specified by the user control activities in the SSAE 16 report) to
verify they are implemented and operating as intended.
10 An independent auditor’s report on the design and operating effectiveness of controls at a service
organization

Example: Implementing or Assessing Control Activities when a Re-

port on Controls at a Service Organization is Not Available
267 Funnell Medi-Quip is a 500-person medical equipment manufacturer that decides to
outsource its treasury function to a service organization, Oxford Financial Experts. A
report on control activities is not available.
268 The management of Funnell Medi-Quip evaluates the nature of the control activities
of Oxford Financial Experts and its own control activities over Oxford. The manage-
ment team determines that the risk of material misstatement associated with the
financial statement assertions affected by the processes of the Oxford is quite high.
Funnell Medi-Quip concludes that additional information is needed to evaluate the
design and operating effectiveness of Oxford’s control activities. The management
team performs tests at Oxford, using the internal audit group to verify that the control
activities are implemented and operating as intended. Funnell also tests its own user
control activities.
Approach: Considering the Types of Control Activities

269 Once risks have been identified and mapped to relevant financial statement assertions, Integrates with Risk Assessment
management determines relevant business processes and selects and develops control Considers Entity Specific Factors
activities to address each risk. Management considers using automated controls when-
Determines Relevant Business Processes
ever the systems in place make it possible. These are supplemented by manual control
• Evaluates a Mix of Control Activity Types
activities when automated controls are not available. Management also considers a mix
of transaction control activities and business performance reviews. In its selection and • C
are Applied
development of control activities, management considers the likelihood that a control
might fail to operate effectively. In assessing the risk of failure, management assesses Addresses Segregation of Duties
various factors, which may include:
•• The type of control (i.e., manual or automated) and the frequency with which
it operates
•• The complexity of the control
•• The risk of management override
•• The degree of judgment required to operate the control
•• The competence of the personnel who perform the control
•• Any changes in key personnel who perform the control
•• The nature and materiality of misstatements that the control is intended to prevent
or detect
•• The degree to which the control relies on the effectiveness of other controls (e.g.,
general technology controls)
•• The evidence of the operation of the control from prior years
270 Certain financial reporting elements, such as those involving significant account-
ing estimates, related party transactions, or critical accounting policies, will generally

have higher risk for both material misstatement to the financial reporting element
and control failure. In these situations a combination of control activities is usually
selected and developed by management to adequately address the risks of a financial
reporting element.
Example: Balancing the Types of Control Activities

271 During initial compliance efforts, EJ’s Corporation faced uncertainty in determining
how many key controls were needed to achieve management’s objectives. Amid such
uncertainty, a layered control environment was established, and duplicate control
activities since then have been identified. EJ’s management is re-evaluating its existing
controls to:
•• Determine whether duplicate control activities can be eliminated
•• Identify opportunities to implement preventive control activities earlier in the busi-

ness process and eliminate downstream detective control activities
•• Where possible, automate controls and eliminate manual control activities
272 In balancing its control activities within the cash disbursements cycle, EJ’s Corporation

focuses on the following preventive control activities:
•• Restricted Access—Ensuring that different people initiate, approve and record

cash movements.
•• Authorization, Approval, Verification—Clearly defining lines of responsibility and

expectations with written job descriptions. Setting limits for staff authorization and
requiring dual signatures for disbursements in excess of a specified limit, control-
ling access to treasury software program through passwords, access codes and
program permission, and requiring a senior-level individual to review supporting
documents to verify that disbursements are appropriate, valid and in agreement
with the company’s policies.
273 These control activities are complemented with the following detective control activities:
•• Reconciliation—Performing regular, independent comparison of different sets of

data to identify and investigate any discrepancies
•• Monitoring and Performance Reviews—Regularly comparing reported results to

budgets, forecasts, prior periods, and other benchmarks to identify unexpected
results or unusual relationships that require additional follow-up.
Example: Evaluating Preventive versus Detective Control Activities

274 As part of its regular assessment of control activities, Mountain High University reviews
the mix of preventive and detective control activities and finds a high proportion of
detective control activities. It is revealed that the initiators of transactions or the primary
reviewers of third-party financial data are not generally accounting or finance profes-
sionals. Many of those at Mountain High who conduct financial tasks are primarily
focused on academic and research activities or students and donors. To mitigate this
risk, Mountain High changes its procedures to ensure that the detective control activi-
ties are executed by people with appropriate skills and experience.

Example: Setting the Threshold for Business Performance Reviews

275 The senior management of the multinational consumer products company, Zephyr
Corp., reviews the monthly and quarterly income statement and balance sheet analysis
in order to prevent or detect on a timely basis material misstatements to one or more
financial statement assertions. This analysis compares the current year results against
prior year actual results, the current year budget, and the latest forecast. It also includes
key performance indicators such as gross margin, accounts receivable, inventory turn-
over days, and return on equity.
276 To begin the analysis, the CFO of each of the company’s five business units reviews
the balance sheet and income statement in detail to identify and explain any variances
from budget and prior year actual results over a predetermined threshold (which varies
by business unit). The threshold, which ranges from 5% to 10% of pre-tax income, has
been developed by senior management to help detect potentially material differences
considering the following factors:
•• Significance of the business unit in relation to the group
•• The nature of assets and liabilities and transactions executed at the business

unit, including significant transactions or initiatives undertaken outside the normal
course of business
•• Specific risks associated with the business unit
•• Degree of centralization of processes and financial reporting applications
•• The effectiveness of the control environment at the business unit
•• Results of past monitoring activities by the company
•• Potential for error to exist at the business unit
277 The analysis is then submitted to Zephyr’s corporate center for review. Senior manage-
ment hold monthly meetings with the representatives from each business unit (usually a
business unit CFO) to understand why there are significant differences that are exceed-
ing predefined thresholds and to determine whether corrective action is necessary.
Example: Controlling Significant Accounting Estimates

278 Finance management at the Judge Mint Company (JMC) is responsible for prepar-
ing accounting estimates relating to the valuation of trade receivables on a monthly
and quarterly basis. Management estimates the underlying allowance for uncollectible
receivables considering:
•• Historical percentages of uncollectible receivables to total receivables
•• Historical collections and write-offs relating to customers with specific receivables

outstanding at period end
•• Judgments relating to customers’ ability and intent to pay.
279 Management’s assessment of customers’ ability and intent to pay outstanding receiv-
ables is subjective and susceptible to error. Accordingly, management selected, imple-
mented, and deployed a mix of control activities to help mitigate this valuation risk,
including the following:

•• The treasurer periodically reviews existing customer’ historical financial and credit
information as provided by Dun & Bradstreet to identify any changes in the cus-
tomers’ ability to pay.
•• Automated preventive controls are embedded within JMC’s ERP system support
generation of sub-ledger reporting, including historical aging, collection, and
write-off of receivables by customer, which provides a level of consistency for the
completeness and accuracy of reporting used in making estimates.
•• Specific adjustments proposed by accounting personnel knowledgeable about

customers must be supported by analyses including reasons for such adjust-
ments (e.g., communications, disputes, payments, write-offs).
•• The assistant controller approves proposed adjustments to the calculated prelimi-

nary estimate for specific uncollectible receivables based on review of supporting
analyses and information.
•• The controller assesses the reasonableness of final estimate by reviewing the

rationale supporting the selection of the historical percentage used to calculate
the preliminary estimate and the rationale supporting any material adjustments,
and considering the consistency with her knowledge of industry, business, and

customer trends/events.
Example: Automating Balance Sheet Reconciliations

280 Gentry Co., a large decentralized industrial products company, has identified the
account reconciliations part of the financial reporting process as a critical control
activity for reducing the risk of material misstatement in the financial statements.
The number of accounts in the company’s books has increased significantly over the
years as new processes and transactions have been added, other entities have been
formed or acquired, and the number of employees has grown. Today, a large volume
of accounts are reconciled manually on a monthly basis, but this is a time-consuming
process that is prone to error.
281 Gentry Co. is considering implementing account reconciliation software, which would
help automate the process and allow Jeremy Brewster, who is responsible for the
process, to spend more time on the more subjective and complex areas of account
reconciliation.
282 Gentry has identified the following benefits that would arise out of using an automated
account reconciliation tool:
•• A continuous controls monitoring framework would be able to identify significant

and material reconciling items, allowing management to quickly respond to poten-
tial issues.
•• Adjusting entries would be identified and efficiently recorded, followed by a review

by Mr. Brewster.
•• Labor and cost would be reduced.
•• Automation would integrate seamlessly with ledgers, sub-ledgers, and other

financial systems.

•• Exception management would reduce exposure to risk by establishing an action

plan for all exception items.
•• Reconciliation processes would be integrated into the email system,

automating workflow.
283 Gentry Co. decides to implement a partial automated process. It uses both qualitative
and quantitative factors to determine which reconciliations will be automated and which
will continue to be manual. The factors considered favorable to automation include
low complexity of transactions, absence of significant judgments and estimates, low
number of manual journal entries and adjustments, low susceptibility of transactions to
fraud, and high-volume, low-dollar value of transactions, combined with low degree of
variation against the expected account balance.
Approach: Considering Alternative Control Activities to the Segre-

gation of Duties
284 Where resource or other constraints compromise the ability to appropriately segregate Integrates with Risk Assessment

duties, management considers alternative control activities, such as timely periodic Considers Entity Specific Factors
management reviews of reports that are prepared in sufficient detail for misstatements
to be identified.
C
Example: Using Alternative Control Activities when Access to Pur-
are Applied
chasing Transactions Are Not Segregated11
• Addresses Segregation of Duties
285 Luther Optical is a multi-million-dollar designer, manufacturer, and distributor of con-
sumer and industrial optical products. There are two staff members in the purchasing
department, each of whom is authorized to prepare, authorize, and issue purchase
orders up to $5,000. Because no one reviews these purchase orders before they are
sent to vendors, there is a risk that unintentional errors or intentional fraudulent acts will
result in inventory valuation errors, obsolescence, or shortages due to diverted ship-
ments. To reduce this risk to an acceptable level, management relies on a combina-
tion of control activities carried out by other staff members. These include, but are not
limited to the following:
•• An inventory clerk documents and tracks all inventory levels, reducing the risk
of obsolescence.
•• An inventory receiving clerk evaluates, documents, and reports to manage-

ment unusual inventory movement, such as excessive ordering that could lead
to obsolescence.
•• A payables clerk matches invoices to purchase orders and receiving

reports before amounts are paid, reducing the risk of errors resulting from
diverted shipments.
•• A controller reviews exception reports of all inventory purchases with a price more
than 10% above current average costing.
11 This example is likely to be most relevant for smaller entities or the smaller sub-units of larger entities.

Approach: Identifying Incompatible Functions

Integrates with Risk Assessment 286 Using automated tools, organization charts, process flowcharts, or other means by
Considers Entity Specific Factors
which activities are documented, management identifies incompatibilities in func-
tions that are needed to appropriately segregate duties. These incompatible functions
are considered when developing or revising the policies for granting access to assets
Evaluates a Mix of Control Activity Types and systems. The policies are regularly updated to reflect changing responsibilities
C
onsiders at What Level Activities and activities.
are Applied
• Addresses Segregation of Duties Example: Using Automated Tools to Enforce the Segregation of
Incompatible Functions
287 Frencorp is a multi-billion-dollar public industrial products manufacturer. Recently it
installed and configured a governance, risk, and compliance access management appli-
cation. The purpose is to assess sensitive access and segregation-of-duty risks and
conflicts during the development of security roles and the assignment of those roles to
end users. The application allows Frencorp to define processes and transactions that
should not be combined in a security role or assigned to the same end user. It prevents
the assignment of any access that is deemed incompatible.

288 Furthermore, the application routinely scans security roles and end-user access, gener-
ates reports of access risks and conflicts, and routes the reports to the appropriate
people for review. If a user requires access to conflicting transactions, the applica-
tion recommends a mitigating control activity. Frencorp management’s review of the
access risks and conflicts reports and mitigating control activity decisions are logged in
the application.

Control Activities | Selects and Develops General Controls over Technology
Selects and Develops General Controls over

Technology
Principle 11. The organization selects and develops
general control activities over technology to support the
achievement of objectives.
Points of Focus
289 The following points of focus may assist management in determining whether the prin-
•• Determines Dependency between the Use of Technology in Business Pro-

cesses and Technology General Controls—Management understands and
determines the dependency and linkage between business processes, automated
control activities, and technology general controls.
•• Establishes Relevant Technology Infrastructure Control Activities—Manage-

ment selects and develops control activities over the technology infrastructure,
which are designed and implemented to help ensure the completeness, accuracy,
and availability of technology processing.
•• Establishes Relevant Security Management Process Control Activities—

Management selects and develops control activities that are designed and
implemented to restrict technology access rights to authorized users com-
mensurate with their job responsibilities and to protect the entity’s assets from
external threats.
•• Establishes Relevant Technology Acquisition, Development, and Maintenance

Process Control Activities—Management selects and develops control activities
over the acquisition, development, and maintenance of technology and its infra-
structure to achieve management’s objectives.

Approach: Using Risk and Control Matrices to Document Technol-

ogy Dependencies
• Determines Dependency between the 290 Management documents the underlying technology that supports control activities in
Use of Technology in Business Processes risk and control matrices, flow charts, or narratives. Using this information, manage-
and Technology General Controls ment can document the linkage between control activities and technology. Management
E stablishes Relevant Technology should understand which aspects of technology (infrastructure, security, technology
Infrastructure Control Activities acquisition, development, and maintenance processes) are important to the continued,
E stablishes Relevant Security Management proper operation of the technology and any associated automated controls.
Process Control Activities
E stablishes Relevant Technology Example: Using a Walkthrough to Understand
Acquisition, Development and Maintenance Technology Dependencies
291 A global publicly traded information services organization, Signal Corp., recently
acquired a privately held newspaper chain. During the due diligence process, Signal
Corp. determined that the management of the newspaper chain did not have a good
understanding of which applications were critical to the integrity and reliability of its

financial information. To assess this linkage, the internal audit department of Signal
Corp. performed a walkthrough of each of the newspaper chain’s significant financial
processes and documented in a process flow diagram all the applications that sup-
ported these processes. These included the automated controls and any controls that
depended on system-generated reports.
292 The walkthrough covered each major class of transactions. The internal audit team
asked the relevant personnel of the newspaper chain about all significant aspects of
the process.
Approach: Evaluating End-User Computing

• Determines Dependency between the 293 Management understands the use of end-user computing, which includes spread-
Use of Technology in Business Processes sheets, that supports its financially significant processes and associated control
and Technology General Controls activities. Management assesses the risks of a misstatement resulting from an error in
• E stablishes Relevant Technology one of these end-user computing applications. Based on the level of risk, management
Infrastructure Control Activities selects and develops general control activities over the technology covering the relevant
• E stablishes Relevant Security Management processes over:
•• Technology infrastructure
• E stablishes Relevant Technology
Acquisition, Development and Maintenance •• Security management
•• End-user computing development and maintenance
294 For high-risk end-user computing applications, management considers converting to an

IT-supported application.

Example: Evaluating Financial Close End-User Spreadsheet

Control Activities
295 Smythe & Smythe International recently evaluated the use of spreadsheets in its finan-
cial close process. In doing so, it identified that the spreadsheets supporting the calcu-
lation of LIFO (last-in, first-out) reserve and the fair value of goodwill, intangible assets,
and debt were critical, based on their inherent risk, susceptibility to error, and signifi-
cance to the financial statements.
296 Smythe & Smythe also classified the spreadsheets as high in complexity because they
included the use of macros and multiple supporting spreadsheets to which cells and
values were interlinked. The spreadsheets were used either as the basis for journal
entries into the general ledger (LIFO reserve) or as financial statement disclosures (fair
value of goodwill, intangible assets, and debt).
297 The company considered the security, maintenance, and update risks of the spread-
sheets and then selected and developed the following control activities:12
•• Input Control—Input data is reconciled to source documentation to cover its com-

pleteness and accuracy.

•• Access Control—File-level access to the spreadsheets on a central server is
limited to approved users, and a password is required to access the LIFO reserve
spreadsheet.
•• Version Control—Standard naming conventions and directory structures are in

place so only current and approved versions of the spreadsheets are used.
•• Calculation Testing—When changes to formulas are made they are tested against
a manual calculation for accuracy. All spreadsheet formulas are checked for accu-
racy at least once a year.
•• Overall Analytics—Analytical business process reviews using pre-established

thresholds based on operating income and working capital function as a detective
control to find errors in any of the spreadsheets.
Approach: Implementing or Assessing Control Activities when Out-

sourcing IT Functions to a Third Party
298 Management outsources certain aspects of its IT infrastructure to an outside service • Determines Dependency between the
provider, which may or may not have a “report on controls at a service organization” Use of Technology in Business Processes
and Technology General Controls
following an appropriate local or international standard. If a report is available, manage-
ment uses it to determine what financially significant IT processes are covered, whether • E stablishes Relevant Technology
Infrastructure Control Activities
appropriate controls are in place at the service organization, and what controls are
required in its own organization to mitigate risks to external financial reporting to an • E stablishes Relevant Security Management
acceptable level.
Acquisition, Development and Maintenance
12 Note that not all of these controls activities are technology general controls only. The first and last bullets
could be considered business process level controls; however the entire list is included to illustrate a more
complete consideration of spreadsheets.

299 If an appropriate report does not exist, management uses internal resources (e.g.,
internal audit) to review the controls at the third party, verifying that the combination of
the company’s controls and those at the service organization mitigate risks to external
financial reporting to an acceptable level.
Example: Obtaining a Report on Controls at a Service Organization

from a Cloud-Based Service Provider
300 E-Book Frontier, a retailer of electronic books, has outsourced its enterprise resource
planning (ERP) application to a cloud-based service provider (CSP). To prepare for its
initial public offering, the company began to develop and implement a system of internal
control in support of its anticipated external financial reporting objectives. E-Book Fron-
tier uses the ERP application to support its revenue, inventory, purchasing, and pay-
ables processes so the application supports a number of financial statement line items
and their associated assertions.
301 To that end, the management of E-Book Frontier assessed the risks associated with the
business processes outsourced to the ERP cloud service provider and determined a
number of control activities and information requirements that needed to be addressed.

E-Book Frontier management obtained a Statement on Standards for Attestation
Engagements (SSAE) No. 16 (SOC 1) report on internal controls prepared by a third-
party service auditor. As part of the development and implementation of internal con-
trols across the end-to-end business processes managed in part by the CSP, E-Book
Frontier incorporated the review of the audit report as a control activity. In performing its
review, management noted the following:
•• The scope of the report included certain application controls and technology
general controls that were evaluated for both design and operating effectiveness.
The controls relating to the customized configuration for the organization were not
addressed in the service auditor’s report. Management evaluated the impacted
business process and related financial reporting risks and selected and devel-
oped additional actions and control activities to address these risks.
•• The tests of controls covered a time period that correlated with ten months of
the company’s fiscal year, resulting in a gap of the last two months. Based on
management’s analysis on the relevance and risk of the related controls, E-Book
Frontier determined that corroborative inquiry with the CSP would be adequate for
the gap period. To evaluate the continued operation of the CSP controls, man-
agement interviewed key CSP personnel to assess whether any changes in the
controls or known failures had occurred since the date of the report.
302 Management reviewed the results of the tests of controls and the service auditor’s
opinion on the operating effectiveness of the controls to determine whether each control
objective was achieved. Two exceptions were noted in the report, and management
reviewed the additional information related to these that was provided by the CSP in the
unaudited portion of the report. They concluded that one exception was not relevant to
their organization. For the second exception, additional procedures were needed.
303 The second exception related to evidence of customer approval of program changes;
management evaluated the sufficiency of E-Book Frontier’s controls over approval of
changes requested to be performed by the CSP. In addition, it requested a report of all

changes for the past six months from the CSP and verified that the report of all changes
is complete and accurate. It then compared the list of changes and noted no variances
from its internal records.
304 Based on these additional procedures, management concluded that the exceptions did
not result in a deficiency of their system of internal control.
Approach: Configuring the IT Infrastructure to Support Restricted

Access and Segregation of Duties
305 The applications, databases, operating systems, and networks that support financially Determines Dependency between the
Use of Technology in Business Processes
significant processes are configured to support restricted access to financial applica-
tions and data consistent with the organization’s policies and procedures. The con-
figuration includes a means to authenticate users or systems and enforce restricted E stablishes Relevant Technology
access, as well as key parameters, such as minimum password length and the aging
of passwords. • E stablishes Relevant Security Management
E stablishes Relevant Technology
Example: Configuring the IT Infrastructure to Support Restricted

Access and Segregation of Duties Process Control Activities
306 Woodlawn Wireless Telecommunications, which has over 50 applications critical to its
financial reporting process, was recently cited for poor infrastructure security controls
by its internal audit group. Specifically, the setup of key security parameters, such as
password length and complexity, was not consistently applied across these applica-
tions, and in many cases they were below industry good practices. To correct the situa-
tion, Woodlawn developed a four-step approach:
•• Create a three-tier risk rating of the importance of an application and its data to
the reliability of the financial-reporting process.
•• Develop policies for the settings of key security parameters for every technology
in use at the company for each risk rating level.
•• Assess the importance of each application and its associated infrastructure to the
reliability of financial reporting and assign it a risk rating.
•• Implement procedures to put in place and monitor compliance with the policies
for each application consistent with its associated rating.

Approach: Configuring IT to Support the Complete and Accurate

Processing of Transactions and Data
Determines Dependency between the 307 Management selects and develops control activities so that transaction processing,
Use of Technology in Business Processes whether batch or real-time, is complete and accurate. Processing is actively checked
and Technology General Controls for problems, either through a manual review of system status and logs or by automated
• E stablishes Relevant Technology programs with alarms. Timely corrective action is taken when problems are identified.
Infrastructure Control Activities Critical financial data and programs are regularly backed up and procedures are in
E stablishes Relevant Security Management place to completely and accurately do a restore. The restoration process is regularly
Process Control Activities tested to help ensure the backup and restoration processes work properly.
Acquisition, Development and Maintenance Example: Configuring IT to Support the Complete and Accurate
Processing of Transactions and Data
308 In the data center of Sullivan Financial Services, the IT operations staff monitors the
batch and real-time processing of applications (including all financially significant
applications) for errors using automated software. The scheduling software on the main-
frame application checks for various problems with batch jobs, including data errors
and programs that don’t complete properly or that run out of order. The operators are
alerted to any of these issues and alert the appropriate business process owner based

on standard documented procedures.
309 For applications that process in real time, software is also used to automatically monitor
for errors, such as incomplete or inaccurate record transfers between systems. When
a possible error is detected, the software attempts to resend the record without error.
If the error persists, an email alert is sent to an operator who corrects the error follow-
ing standard documented procedures. Financial management is notified of any errors
in a weekly report. The weekly report is reviewed to determine if any accounting record
adjustments are required due to the system problems. The controller reviews and
approves any changes. (Note this could be considered a process-level control.)
Approach: Administering Security and Access

Determines Dependency between the 310 Financial management establishes policies that define appropriate access rights to be
Use of Technology in Business Processes consistent with job functions, including segregation of duties, for financially significant
and Technology General Controls applications and processes. New access requests or changes to access are reviewed
E stablishes Relevant Technology against the policy by the functional owner of the IT resource (i.e., application, database,
Infrastructure Control Activities operating system, or network). The owner of the IT resource periodically recertifies
• E stablishes Relevant Security Management access to ensure it is commensurate with policy. Problem reports, such as excessive
Process Control Activities improper logins, are regularly reviewed, and follow-up actions are taken when issues are
E stablishes Relevant Technology identified.
Example: Establishing Logical Security
311 The management team of a compensation and benefits consultancy, reviews logical
security controls to prevent unauthorized access to its financial reporting systems
as follows:

•• User Accounts—Formal user account set-up and maintenance procedures are in

place to request, establish, issue, suspend, change, and delete user accounts.
•• Authentication Controls—Authentication standards establish minimum require-

ments for password length and a finite number of login attempts. Only unique user
IDs are used to promote accountability and auditability.
•• Privileged Accounts—The use of privileged (“super-user”) accounts is limited to

two-system and application administrators who are responsible for IT security
management and therefore deemed appropriate. These accounts are monitored
by management for improper use.
•• Application Reviews—The configuration settings for who has access to data

related to critical applications, and systems are periodically reviewed. Any viola-
tions detected are reported to management and corrective action is taken.
•• Security Reviews—Applications and systems generate security logs, enabling user

activity to be monitored and security violations to be reported to management.

Approach: Applying a System Development Life Cycle over Pack-
aged Software
312 Management considers many factors when selecting new packaged software, including Determines Dependency between the
Use of Technology in Business Processes
functionality, application controls, security features, and data conversion requirements.
Management utilizes competent internal resources or hires a third-party vendor to
implement the software, following the organization’s requirements. E stablishes Relevant Technology
313 Management follows a defined change-control process to implement system upgrades E stablishes Relevant Security Management
or patches. This includes assessing the nature of the upgrade or patch and whether Process Control Activities
it is appropriate to implement. If deemed appropriate, the patch or upgrade is system • E stablishes Relevant Technology
and user tested in an environment that mirrors production before being implemented. Acquisition, Development and Maintenance
Key stakeholders, such as the functional users, finance, and IT, sign off on the change Process Control Activities
before it is implemented. Appropriate documentation is maintained to provide evidence
that the changes have been made.
Example: Managing Changes to Packaged Software

314 FabFun Toys is a manufacturer of plastic toys. For several years, it has been using
packaged general ledger software, and it has developed a set procedure for managing
vendor announcements of software upgrades, which is as follows:
•• Obtain a description of the change, the rationale for it, the impact on the com-
pany’s security environment, and implications for user interfaces.
•• Outline steps for a back-out plan should the upgrade not perform as expected.
•• Develop a plan to test that the edit and validation rules work properly, desired
system functions operate as expected and produce the desired results, undesired
processing results are prevented, and existing technical capabilities, including
control activities critical to external financial reporting, continue to work properly.

•• Execute the tests and document the results.
•• Maintain a change control log.
•• Obtain approval from financial and operational management and end users of the
test results prior to releasing the upgrade into production.
Approach: Applying a System Development Life Cycle over Soft-

ware Developed In-House
Determines Dependency between the 315 Management follows a full system development life cycle (SDLC) covering problem fixes
Use of Technology in Business Processes to major implementations. The SDLC covers a number of process steps and control
and Technology General Controls activities, including the following:
Infrastructure Control Activities •• Initiation, Authorization, Tracking, and Analysis—Changes are captured in a
change control or development specification. The change’s progress is tracked
E stablishes Relevant Security Management
and authorization to proceed is made by the appropriate stakeholders. The pos-
sible impact to internal controls over financial reporting is assessed, and changes
are approved by relevant financial stakeholders.

Process Control Activities •• Design and Construction—Programming standards are followed during the design
phase and procedures are put in place to provide version control.
•• Testing and Quality Assurance—Testing is performed before going live to check if

the change meets the specification and has not caused any unintended changes
to the existing software. The amount and type of testing varies based on the
nature of the change (size, complexity, etc.) and includes unit, system, integration,
and user acceptance testing, as appropriate.
•• Data Conversion—When applicable, data is converted completely and accurately

from the previous technology.
•• Program Implementation and Go-Live Authorization—The change is approved by

the relevant stakeholders before going live, and only the approved version of the
software is implemented.
•• Documentation and Training—End-user and IT support documentation and train-

ing are created and updated as needed.
Example: Managing Changes to Custom Software

316 Summer Run Co. provides material-based solutions for electronic, acoustical, thermal,
and coated metal applications. IT has recently decided to significantly modify inven-
tory management software, which is considered a financially significant application. To
do so, the company must rely on the only two developers on staff to develop, test, and
migrate the software to production.
317 Because Summer Run does not have an automated code promotion utility to control
versions and migrations to the production environment, the IT manager, James Robb,
takes the following steps:

•• Identifies and analyzes risk resulting from the required changes
•• Assigns changes to developers so that each works on specific tasks only
•• Assigns to the developer not working on a particular change the responsibility for
testing the change and migration to production
•• Reviews any significant changes
•• Locks versions following user acceptance testing to prohibit further change prior
to release
318 Mr. Robb also relies on these manual controls to manage the code version
and migration:
•• He creates a manual log listing the version of the code copied to the development
environment, along with date and time, and manually tracks the migration to test
and then to production.
•• He separates the review of all version control procedures prior to moving the
code to production from those performed by the individual responsible for the
IT functions.

319
Example: Varying Control Activities in an SDLC Based on Risk
The multi-billion-dollar telecommunications organization, Brassen Systems, uses an
SDLC to update and maintain more than 200 applications. The changes vary from large
and complex development initiatives to simple report changes. Brassen seeks to match
the degree and rigor of control activities to the range of risks of these changes.
320 The organization assigns the level of risk to one of four categories based on several
factors, including the length, level of effort, possible risks to financial processing and
control activities, and complexity of the change. Level 1 changes (the most risky) are
required to go through twenty quality gates, or control points, before implementation,
while Level 4 changes (the least risky) are required to go through only ten gates. All
changes that may affect financial processing and control activities are required to be
reviewed by someone in the finance department before being implemented.

Deploys through Policies and Procedures

Principle 12. The organization deploys control activities
through policies that establish what is expected and
procedures that put policies into action.
Points of Focus
•• Establishes Policies and Procedures to Support Deployment of Management’s

Directives—Management establishes control activities that are built into business
processes and employees’ day-to-day activities through policies establishing
what is expected and relevant procedures specifying actions.
•• Establishes Responsibility and Accountability for Executing Policies and Pro-

cedures—Management establishes responsibility and accountability for control
activities with management (or other designated personnel) of the business unit or

function in which the relevant risks reside.
•• Performs in a Timely Manner—Responsible personnel perform control activities

in a timely manner as defined by the policies and procedures.
•• Takes Corrective Action—Responsible personnel investigate and act on matters

identified as a result of executing control activities.
•• Performs Using Competent Personnel—Competent personnel with sufficient

authority perform control activities with diligence and continuing focus.
•• Reassesses Policies and Procedures—Management periodically reviews

control activities to determine their continued relevance and refreshes them
when necessary.

Control Activities | Deploys through Policies and Procedures
Approaches to Applying the Principle
Approach: Developing and Documenting Policies and Procedures

322 Management develops and documents policies and procedures for all significant • Establishes Policies and Procedures to
Support Deployment of Management’s
external financial reporting–related control activities. Procedures are documented using
Directives
various formats, such as narratives, flowcharts, and control matrices. Management
develops a standardized format for policies and procedures, which may include: • E stablishes Responsibility and
Accountability for Executing Policies and
•• Reasons for the policy and procedure, including the risks to the achievement of Procedures
management’s objectives • Performs in a Timely Manner
•• Locations, units, and processes to which the policy and procedure applies • Takes Corrective Action
• Performs Using Competent Personnel
•• Roles and responsibilities for owning, creating, implementing, executing, and
maintaining the policy and procedure • Reassesses Policies and Procedures
•• Matters covered by the policy and procedure, including corrective action to be

taken as part of performing the control activity
•• Escalation procedures for policy exceptions

•• Cross-references between associated policies and procedures
•• Required competency of personnel performing procedures
•• Required timeframe for performing procedures
•• Review date
Example: Using Templates to Document Policies

323 Greyson Gas, a natural gas utility, uses a standardized template to format its policies.
Its loss contingencies policy helps ensure that transactions are recorded as necessary
to permit preparation of financial statements in accordance with generally accepted
accounting principles. The policy includes the following sections:
•• Purpose—This policy establishes criteria that are to be used to determine if a loss

contingency should be recorded in the financial statements.
•• Location and Applicability—This policy applies worldwide to any unit of any

company owned fully or partially, either directly or indirectly through a subsidiary,
by the company, whether consolidated or accounted for by the equity method.
•• Key Provisions—A definition stating what constitutes a contingency is included

and related accounting model is described.
•• Roles and Responsibilities—Descriptions are provided for everyone involved in the

loss contingencies identification, accounting, and disclosure process including
the timeframe for completion. This includes each location’s senior financial execu-
tive notifying the group’s senior financial executive and the corporate controller of
the existence of an actual or potential loss contingency, including the facts and
circumstances giving rise to the possible loss and the estimated amount of such
loss. Existing actual and potential loss contingencies are reviewed and evaluated
on an ongoing basis (not less than once each calendar quarter) by each location’s
senior financial executive. As a part of this review, the current status, including

revised estimates for each loss contingency, is reported to the corporate control-
ler. Information required for the disclosure of loss contingencies is provided to the
corporate office by location in quarterly financial/legal reporting in a prescribed
template. The template is updated, as necessary, through and including the date
of the related public filing.
•• Escalation Procedure for Exceptions—All instances of identified non-compliance

with accounting policy must be referred to the corporate controller and the
appropriate business unit CFO. All accounting policy exception requests must be
referred to the appropriate business unit CFO for preliminary approval, and then
submitted to the corporate controller for final approval.
•• Review Date—The policy is reviewed every two years or when circumstances

change for compliance with certain criteria, such as legal and regulatory require-
ments; applicable rules and regulations; relevance; and appropriateness in sup-
porting business objectives.
324 A record of all accounting policy changes, additions, and retirements is maintained,
which includes revision number and date, effective date, a brief description of the
changes made, and the person who approved the change.
Draft for Discussion 325

Example: Establishing Policies and Procedures
A national trade association establishes a policy that all payments must be appro-
priately authorized before cash is remitted. It uses an authorization approval matrix
for expenditures.
326 The board of directors reviews and approves the annual budget, over and above the
required approval provided by the CEO. Authorization to incur liabilities on behalf of the
trade association is limited if they fall outside of the amounts approved in the budgeting
process for normal operations. The limits are:
•• Board of directors: $50,000 or more
•• CEO: Up to $50,000
•• Vice-presidents: Up to $10,000
•• Staff directors and managers: Up to $2,500
•• Supervisors: Up to $500
327 Siobhan O’Reily, the association CEO, must review and approve in writing any capital-
ized purchases above $10,000. A purchase order must be prepared for all purchases,
and every disbursement of funds requires the receipt of an invoice.This policy does not
apply to the purchase of association investments, which are authorized by the board of
directors through its corporate investment policy.
328 Ms. O’Reily reviews all purchase orders for more than $10,000 for appropriateness. She
compares the amounts to budget, and if she uncovers a discrepancy, she sends the
purchase order back for investigation and follow-up.

Example: Reassessing Policies and Procedures for

Revenue Recognition
329 A large multinational software provider revised its revenue recognition policy due to the
risk that lucrative sales commissions have tempted sales personnel to record software
orders improperly. Depending on the nature of the software sale, there are different
commissions paid to sales personnel. Also, depending on product code, there are dif-
ferent revenue recognition requirements; some products require revenue recognition
at the time of sale whereas others require revenue to be recognized over time. Sales
personnel occasionally record sales under the wrong product codes, which leads to
inappropriate recognition of revenue and sales commissions.
330 The CEO and CFO approved modifications to the company’s revenue recognition
policy and related approval matrix that requires all significant software contracts be
reviewed by the CFO and other finance personnel before software revenue and sales
commissions are recognized. In addition, finance, legal, and sales personnel collabo-
rated in establishing standard contractual terms and conditions that would result in
proper recognition of revenue and commissions, and identifying variances from such
standards that would require review and approval by the CFO and/or other finance

personnel with appropriate technical competencies in applying the company’s revenue
recognition policy.
331 In addition, the CFO, sales executives, and legal staff meet annually with sales person-
nel to review the company’s policies, its standard and non-standard contractual terms
and conditions, its historical revenue recognition issues, and any specific commercial
arrangements to avoid. All subsidiary sales and finance personnel attend annual training
that focuses on how to comply with local laws and regulations and with the company’s
revenue recognition policies and procedures.
Example: Reviewing Cost Overruns

332 The CFO of Boxtop Construction, Suri Navrat, evaluates the process and control activi-
ties for assessing cost overruns. She determines that the project manager, George
Whitfield, is critical to the process because he is skilled in understanding client needs
and project requirements and in analyzing the effects of the alternatives on the project
costs and schedule, and, ultimately, the revenues over the project’s lifetime.
333 Mr. Whitfield periodically reviews actual costs incurred for a long-term project, ensur-
ing they are accurate, that indirect costs are appropriately allocated, and that change
orders and potential cost overruns do not exceed the authorized funding. If any vari-
ances from the cost baseline appear, he promptly investigates them and excludes incor-
rect or inappropriate changes from the reported cost or resource usage, which is used
as the basis for revenue recognition for the period. He also reviews the estimated costs
for reasonableness, taking into account the actual stage of construction at the end of
the reporting period.
334 At the end of each period, Ms. Navrat reviews the reasonableness of key assumptions
used in Mr. Whitfield’s analysis. As part of her review, Ms. Navrat compares the sum
of actual costs plus those still to be incurred against authorized funding to determine
whether the revenue recognized to date based on the costs incurred and estimated
costs to complete are appropriate, including whether the project will result in a loss at
completion. If so, the loss is recognized immediately.

Example: Performing Control Activities in a Timely Manner

335 A large for-profit educational institution, Learn Now College, promptly deactivates or
removes access rights to the general ledger from employees that no longer require
them. Several steps are followed in this process:
•• When an employee is terminated or transferred, a Termination Personnel Action

Form/Employee Clearance Form is completed. This form includes a security
section, which is completed by someone in the finance department. This section
indicates that an information systems change order has been submitted to delete
system access permissions for a particular employee.
•• The IT group sends a confirmation to the finance department and human

resources when the change order is completed.
•• The human resources department maintains a list of open change orders that is
reviewed daily for receipt of the confirmation from the IT department. If a receipt is
not received within twenty-four hours, a human resources representative follows
up with the IT group until the request is processed.
Example: Taking Corrective Action

336 As part of performing business performance reviews, management of White and Stack
Co. reviews the results of its business unit performance, comparing the actual results
for the current three-month period with budgets and prior period actual results. The
management team observes any significant shortfall in current results compared with
the budget, and any existence of performance-based bonus accrual to be paid out
when actual performance exceeds budgeted results. Management follows up on the
results of its top-level review, identifying any overstatement in bonus accrual.13 Correc-
tive action is taken as necessary by adjusting the amount recorded for bonus payouts.
Approach: Deploying Control Activities through Business Unit or

Functional Leaders
• Establishes Policies and Procedures to 337 Business unit or functional leaders deploy control activities in their areas of responsibil-
Support Deployment of Management’s ity by building the policies and procedures into their organization’s day-to-day activi-
Directives
ties. In some cases, a centralized control function or team works with the business unit
• E stablishes Responsibility and or functional leaders to help deploy policies and procedures consistently across the
Accountability for Executing Policies and organization. The policies and procedures are communicated in various ways, includ-
Procedures
ing running training programs, holding meetings, and distributing formal and informal
Performs in a Timely Manner documentation.
Takes Corrective Action
Performs Using Competent Personnel Example: Deploying Control Activities through a Central
Reassesses Policies and Procedures Control Function
338 A federal agency has identified its most significant financial reporting risk as the mis-
classification of expenditures as capital or expense. As a result, the agency director has
mandated far-reaching organizational changes in procedures and control activities.
13 Investigation of the root cause of why the overstatement occurred is discussed in Chapter 5,
Monitoring Activities.

339 Budget formulation and execution processes and structures have been redesigned
centrally to identify and distinctly categorize funds for capital projects. These have been
distributed to individual departments by the financial planning and budgeting group.
The standard contract has also been modified to require purchased capital items to be
separately identified for each project (by budgetary funding code) and to not include
items for any other projects.
340 The agency has instituted new policies, mandatory annual training, weekly reviews of
pending contract actions, and monthly reviews of expenditures to ensure program com-
pliance. The efforts have dramatically reduced misclassifications and overcome audit
qualifications for plant, property, and equipment reporting.
Approach: Conducting Regular and Ad Hoc Assessments of

Control Activities
341 On a regular basis, or when changes are made to financially significant processes and Establishes Policies and Procedures to
systems, control activity owners in conjunction with financial reporting and control Support Deployment of Management’s
experts review control activity documentation for continued relevance. Changes are Directives

made when redundant, obsolete, or ineffective control activities are found.14 E stablishes Responsibility and
Accountability for Executing Policies and
Procedures
Example: Regularly Assessing Policies and Procedures
Performs in a Timely Manner
342 Central Community Bank maintains a policy checklist on its intranet. The checklist
Takes Corrective Action
references all the pertinent company policies and management’s last review date, next
review date, and board of director review and approval as applicable. The policies Performs Using Competent Personnel
and procedures are reviewed annually, or more frequently if necessary, in response to • Reassesses Policies and Procedures
changes in underlying business processes. The internal audit department assesses
compliance with company policy and procedures in conjunction with its internal
audit reviews.
Example: Ad Hoc Assessing of Control Activities

343 Following a finance effectiveness review, Cymbol Creative, a global paper products
manufacturer, reduced the number of its business unit accounting groups from six to
four, combining accounting for related business operations under one CFO. Follow-
ing the reorganization, the company reassessed and, in certain instances modified, its
control activity policies and procedures to reflect the new organizational structure.
14 This approach applies to changes that are not significant enough to go back through the risk
assessment process.


Components of Internal Control | Information and Communication
5. Information and Communication
Chapter Summary
344 Information is necessary for the entity to carry out internal control re-
sponsibilities to support the achievement of its objectives. Management
obtains or generates and uses relevant and quality information from both
internal and external sources to support the functioning of other compo-
nents of internal control. Communication is the continual, iterative pro-
cess of providing, sharing, and obtaining necessary information. Inter-
nal communication is the means by which information is disseminated
throughout the organization, flowing up, down, and across the entity. It
enables personnel to receive a clear message from senior management

that control responsibilities must be taken seriously. External communi-
cation is twofold: it enables inbound communication of relevant external
information and provides information to external parties in response to
requirements and expectations.
Principles relating to the Information and Communica-

tion component
13. The organization obtains or generates and uses relevant, quality

information to support the functioning of other components of
internal control.
14. The organization internally communicates information, including

objectives and responsibilities for internal control, necessary to
support the functioning of other components of internal control.
15. The organization communicates with external parties regarding

matters affecting the functioning of other components of
internal control.

13. The organization obtains or •• Creating an Inventory of Information

generates and uses relevant, Requirements
quality information to support
•• Obtaining Information from External Sources
the functioning of other com-
ponents of internal control. •• Obtaining Information from Non-Finance
Management
•• Creating and Maintaining Information

Repositories
•• Using an Application to Process Data

Into Information
•• Enhancing Information Quality Though a Data

Governance Program
•• Identifying, Protecting, and Retaining Finan-

cial Data and Information

14. The organization internally •• Communicating Information Regarding
communicates information, External Financial Reporting Objectives and
including objectives and Internal Control
responsibilities for internal
•• Communicating Internal Control
control, necessary to support
Responsibilities
ponents of internal control. •• Developing Guidelines for Communication to
the Board of Directors
•• Reviewing Financial and Internal Control

Information with the Board of Directors
•• Communicating a Whistle-Blower Program to

Company Personnel
•• Communicating through Alternative Report-

ing Channels
•• Establishing Cross-Functional and Multidi-

rectional Internal Control Communication
Processes and Forums
15. The organization communi- •• Communicating Information to Relevant

cates with external parties External Parties
regarding matters affecting
•• Obtaining Information from Outside Sources
ponents of internal control. •• Surveying External Parties
•• Communicating the Whistle-Blower Program

to Outside Parties
•• Reviewing External Audit Communications

Information and Communication | Uses Relevant Information
Uses Relevant Information

Principle 13. The organization obtains or generates
and uses relevant, quality information to support the
functioning of other components of internal control.
Points of Focus
•• Identifies Information Requirements—A process is in place to identify the infor-

mation required and expected to support the functioning of the other components
of internal control and the achievement of entity’s objectives.
•• Captures Internal and External Sources of Data—Information systems capture

internal and external sources of data.
•• Processes Relevant Data into Information—Information systems process and

transform relevant data into information.
•• Maintains Quality throughout Processing—Information systems produce infor-

mation that is timely, current, accurate, complete, accessible, protected, and
verifiable and retained. Information is reviewed to assess its relevance in support-
ing the internal control components.
•• Considers Costs and Benefits—The nature, quantity, and precision of infor-

mation communicated are commensurate with and support the achievement
of objectives.
Approach: Creating an Inventory of Information Requirements

346 Extensive information is available to management and comes from a wide variety of • Identifies Information Requirements
sources. For information to be relevant, it must be directly aligned to management’s • C
aptures Internal and External Sources
needs and responsibilities for overseeing external financial reporting and monitoring the of Data
internal control system. A process for identifying information requirements and building Processes Relevant Data into Information
an inventory enables management to focus attention on information that directly sup-
Maintains Quality Throughout Processing
ports its needs.
• Considers Costs and Benefits
347 To achieve this, financial management defines common categories and types of infor-
mation that are aligned to external financial reporting objectives and related risks as
specified by management. From these categories, financial management identifies
relevant information from both internal and external sources that are best suited to man-
agement’s needs. Financial management creates an inventory of information and maps

each item to one or more members of management that have a role in external financial
reporting. This inventory is then used to assign responsibility to personnel for gathering
the required information.
348 The following diagram illustrates key categories and types of information senior man-
agement may require in support of external financial reporting objectives:
Information about Analyst reports, Information about

external risks Booking reports,
Competitor bench- internal risks
Mid-month sales,
and trends marking, and trends
Inventory levels,
Acquisition targets, Cash forecasts,
Litigation activities Monthly financial
statements
Internal audit
Stock price, Raw reports, Updates
material pricing, on accounting

Currency rates, pronoucements,
Information about Gross margin, Quarterly Information about
key metricks Average selling certifications regulatory changes
price
Example: Evaluating Business Activities to Identify Information

Requirements
349 Over the past year, a network of health care providers, NetHealth, has experienced
significant growth in the number of patient visits. This has created challenges at the
medical offices in capturing adequate information for the central processing group. The
central processing group relies on adequate information to track and record information
on patient visits, which in turn is used to update insurance reimbursement limits and to
bill patients and insurance companies.
350 The management organization overseeing NetHealth recognizes that timely, relevant
information is needed to support control activities and keep each physician office in
the network up-to-date on patient activities, insurance arrangements, and billing and
collection activities. Consequently, the COO has hired an advisor to interview members
of the central processing group, receptionists, nurses, doctors, and others who work
in physicians’ offices across the network. From these interviews, the advisor provided
the following:
•• Summary of the end-to-end activities of typical patient visits
•• Identification of the information requirements to be gathered during each visit

•• Definition of roles and responsibilities for information gathering to allow the central
processing group to update patient records and process bills accurately and in a
more timely fashion
•• Identification of data flow challenges that were impacting financial transaction

processing and control activities
351 Management is now developing guidelines for gathering information during patient
visits. To reduce the costs of distributing the guidelines to each office in the network,
the IT manager is building a section on the network’s website where the guidelines will
be available and where updates and comments can be posted.
Example: Maintaining Data Flow Diagrams, Flowcharts, Narratives,

and Procedures Manuals
352 The management at Rahmany Marine Group has effectively adopted the use of narra-
tives, flowcharts, data flow diagrams, and procedures manuals to document the end-
to-end process flows that support the corporate internal control and financial report-
ing. These documents are produced so that information about these processes can
be easily understood by users throughout the company, including the IT team, finance

and accounting specialists, systems developers, support personnel, and auditors. This
documentation allows these personnel and other users to identify the source of data,
responsible personnel, storage locations, source systems, relevant transformation pro-
cesses and quality checks, and the primary users.
353 The data flow diagram below illustrates part of the company’s purchasing cycle.*
*Author’s Note: The following data flow diagram does not depict a complete account of all the information
needs for the example. It does depict the flow of information at a high level, but keep in mind that additional
detailed specifics would be included in corresponding narratives, or additional flow diagrams or flowcharts
would show a level deeper.
Company
Personnel Vendor
Updates Purchasing
& Accounting
Dept.
1.0 Process 3.0 Update Vendor
Purchase Requisition Master File
Purchase
Requisition
Purchase System
Vendor Management
Purchase 4.0 Generate Internal

Order 2.0 Generate Reports
Purchase Order Purchasing Reports

Approach: Obtaining Information from External Sources

Identifies Information Requirements 354 Finance personnel often rely on publications, events, and other information from
• C
aptures Internal and External Sources external parties to gather information relevant to performing their responsibilities. The
of Data sources of data and information vary depending on the specific role and responsibilities
• Processes Relevant Data into Information
of the individual. Sources of information may include:
Maintains Quality Throughout Processing •• Subscriptions to industry publications and regulatory updates
Considers Costs and Benefits •• Participation in industry conferences, trade shows, and other events
•• Regular communications, both verbal and electronic, with suppliers, customers,

or third-party service providers
•• Membership and participation in relevant organizations
•• Subscription to third-party mailing lists and blogs that pertain to the industry
and company
•• Industry research reports
•• Peer industry calls and financial fillings

355 Finance personnel evaluate the external information gathered and incorporate sig-
nificant events, trends, and changes into their day-to-day financial reporting or
related internal control responsibilities. In addition, finance personnel ensure that any
announcements about changes to current accounting standards or regulatory require-
ments are summarized, reviewed, and disseminated to the others within the external
financial reporting organization.
Example: Gathering Information from External Sources

356 J. J. Power Utility Corp. offers a learning and development program that includes
guidelines and funding for finance and accounting personnel to attend external training
and conferences. These activities help employees achieve their ongoing professional
educational requirements, maintain their relevant certifications, and develop new skills.
The external training also provides information about new or changed accounting,
disclosure, and internal control requirements, as well as best practices important to
J.J. Power Utility’s business. To supplement the external training sessions, finance and
accounting personnel also subscribe to relevant accounting publications.
357 Accounting and finance personnel meet regularly with the internal audit department to
review and update internal accounting and control policies and procedures based on
the information gathered. In addition, they meet with the CFO to pass on any new infor-
mation and to discuss the impact on financial reporting and policies and procedures.
Accounting and finance managers update policies and procedures to reflect the impact
of the new information.

Example: Capturing Information through Electronic Data

Interchange
358 Mandela & Co., a distributor of electronics products, engages in tens of thousands of
high-volume, low-dollar transactions with customers and suppliers. Historically, sales
orders and invoices for purchasing transactions have been entered and validated
through a combination of manual and semi-automated processes.
359 To reduce time, costs, and errors caused by human intervention, management has
implemented electronic data interchange (EDI) to replace the original process. Relevant
information about key business transactions is now automatically populated into the
company’s ERP system, and automated validation checks are in place to confirm that
information is transmitted completely and accurately. As well, the information gener-
ated through the EDI process is also available to production managers, order manage-
ment, and billing personnel, which allows them to perform control activities to support
proper end-to-end transaction processing, including creating the corresponding
accounting entries.

Approach: Obtaining Information from Non-Finance Management
360 External financial reporting objectives are impacted by non-financial activities that occur • Identifies Information Requirements
throughout the business. Information about new events, changes, or significant trends • C
is needed to support accounting, disclosure, and internal control activities. Therefore, of Data
senior accounting and finance personnel meet at least monthly with management Processes Relevant Data into Information
and personnel in other areas of the business—such as operations, human resources,
• Maintains Quality Throughout Processing
compliance, and product development. During these meetings, information is gathered
Considers Costs and Benefits
verbally and in writing on business events and trends. Topics may include:
•• New or lost significant customers, suppliers, or other stakeholders
•• Rate and impact of employee turnover
•• Unexpected trends, whether negative or positive
•• Indications of unethical or improper behavior
•• Budget versus actual and forecast expectations
•• Contractual, compliance, or regulatory issues
•• Customer or supplier complaints
•• Findings from internal audit reports
361 Accounting and finance personnel summarize the information gathered and meet
with the appropriate member of senior management to evaluate the impact on the
financial statements, internal control effectiveness, or changes needed to policies
and procedures.

Example: Conducting Quarterly Interviews of Operations and

Other Management
362 Juan Fernandez is the chief accounting officer of Friesens Fresh Foods, a perishable
food supplier company. He is responsible for evaluating inventory reserve balances as
part of the monthly close process.
363 Significant changes in purchase commitments, inventory usage trends, product con-
figuration preferences, and cycle count results have impacted the judgments and esti-
mates made in applying the inventory reserves policies. Consequently, Mr. Fernandez
now obtains and reviews reports from the company’s ERP system to identify unusual or
unexpected trends, changes in balances or volumes of transactions, and other relevant
details. He then meets monthly with department heads of customer service, procure-
ment, inventory management, and logistics (who oversee third-party warehouses) to
collect additional information about customers, products, inventory, and balances.
364 Based on these meetings, Mr. Fernandez reviews inventory reserve policies, documents
key data points that impact prior estimates, and prepares an updated analysis support-
ing inventory reserve requirements. The CFO of Friesens then reviews and approves
the analysis as part of her review of the related journal entries during the month-end

closing cycle.
Example: Obtaining Operating Information for Financial Reporting

365 Laccona Electronics, a manufacturer of electrical equipment and components, is
responsible for complying with environmental regulations associated with the compa-
ny’s manufacturing processes, including handling raw materials and operating produc-
tion plants. Laccona’s customer contracts include provisions for monetary damages in
cases where products are determined to be unsatisfactory as a result of compliance
audits performed by environmental agencies. In addition, if the audits are unsatisfac-
tory—that is, they indicate any non-compliance with regulations—Laccona may incur
significant fines.
366 Arlene Gomez, the company controller, obtains monthly reports on operational and
compliance metrics from the chief operating officer. In addition, she reviews periodic
internal audit reports on the company’s adherence to policies and procedures related to
environmental compliance. She uses this information to assess reserve requirements or
disclosures associated with damages provisions. Finally, she summarizes relevant infor-
mation and meets with the CFO quarterly to determine whether changes in accounting
estimates and financial statement disclosures are needed.

Approach: Creating and Maintaining Information Repositories

367 Senior management establishes a policy for handling information that is gathered, • Identifies Information Requirements
produced, and shared throughout the company. The policy is designed to facilitate the • C
efficient capture, use, and reuse of relevant information supplied to management and of Data
personnel across the company. • Processes Relevant Data into Information
Management and employees in external financial reporting roles follow procedures • Maintains Quality Throughout Processing
368
for identifying and categorizing information. These procedures require that attributes Considers Costs and Benefits
about each piece of information be recorded before the information is accepted into the
repository. The attributes may include:
•• Information owner
•• Expected users
•• Sources (including systems and people)
•• Criticality
•• Frequency
•• Process supported

369 The information repositories are subject to control activities that help ensure the com-
pleteness, accuracy, security, validity, and lack of redundancy of the information.
Example: Using Data Warehouse to Facilitate Access to Information

370 International Food Distributors has recently completed an enterprise-reporting project
to identify and inventory information used across the company for external financial
reporting and related internal control. The results of the project were used by the CIO
and CFO to design a company-wide data warehouse and reporting tools that would
support a single source for financially relevant information.
•• The first phase of the project involved creating an inventory of the existing reports
identifying relevant sources and eliminating non-critical and redundant reports.
•• The second phase involved designing and implementing the functional and
technical capabilities needed to capture and store data used to generate relevant
information
•• The third phase involved training end users on techniques for effective input
and extraction of information and reports from the data warehouse using
reporting tools.
•• The final phase involved designing and implementing operating procedures and
control activities over the data warehouse and reporting tools to ensure the com-
pleteness, accuracy, security, and validity of the data and information input and
reports generated.
371 As a result of the project, International Food Distributors has a well-defined inventory of
reports, improved data, and a more efficient process for capturing and using informa-
tion for external financial reporting.

Approach: Using an Application to Process Data into Information

• Identifies Information Requirements 372 Management designs its computer applications to capture data from internal and exter-
C
nal sources, transform the data into information, and maintain the quality of the data
of Data and information throughout processing and reporting. The activities relating to capturing
and processing data about financial transactions (e.g., initiate/enter, authorize, record,
process, and report) are documented in company policies and procedures manuals.
The application design includes automated application controls such as input checks
Considers Costs and Benefits for existence and validity and output checks for completeness and accuracy. It also is
supported by technology general controls.
Example: Data Capture and Processing for the Purchasing and

Payables Cycle
373 Insight Media, Inc., a publishing company, recently implemented the purchasing and
payables module of its existing ERP system. The key goals were to improve data quality,
reduce manual handoffs through automation, and improve information flow and visibility
into purchasing transactions.
374 The implementation project team was led by the controller, who was supported by

employees involved in the purchase to payables process. Workshops were held to
confirm the current end-to-end process and identify important information about
sources of transactions, key data requirements, risks to financial reporting, and informa-
tion required for accounting and reporting. The project team used the results from these
workshops to review the ERP module’s capabilities for automating tasks and controls
such as:
•• Checking that data input was valid, complete, and accurate to electronic sources
•• Passing data between the related transactions to minimize data entry and improve
data consistency
•• Automatically recording the accounting transaction upon data input
•• Automatically reconciling the payables subsidiary ledger to the general ledger
•• Generating exception and analytical reports
375 As a result of the implementation, management of Insight Media gained access to more
accurate, complete, and timely information to perform internal controls over the evalu-
ation of accounting entries and disclosures for accounts payable and accrued expense
balances, purchasing commitments, and expected cash balances.
376 The following diagram was created as a result of the above procedures and assisted
management in identifying the relevant information.

Flowchart: Data Capture and Processing for Comparison between

the Purchasing and Payables cycle adjustments posted and
source documents
Comparison of items
on a list of period-end
recurring entries to
entries recorded
Manual review of the

Vendor Initiates goods received not
Received Invoice
Invoice
invoiced account is
Property performed
Plant & Equipment
Input General General Record Reccuring

Invoice data Ledger Ledger &
Production &
Adjusting Entries
Inventory Vendor/
Product
Cost
Master PO Electronically Automatic Automatic Input Recurring
AP Exception Report
Sent to Vendor of Aged PO Reconciling of Reconciling of &
System
Reviewed Payable to GL Payable to GL Adjusting Entries
Automated
Matching Automated two

Input Purchase AP of Data to Existing -way matching for Record the AP Sub Record AP Sub Close Sub-Ledger
General PO
Order data System Approved Vendor, good/service Invoice Ledger Payment Ledger and Post to GL
Product and purchased
Product Cost
Select Invoice Generate

for Payment Payment
Electronic
Payment
Key Areas Legend:
A Passing data between the related transactions to minimize data entry and
improve consistency.
B Checking that data input was valid, complete, and accurate to electronic
sources.
C Automatically recording the accounting transaction upon data input.
D Automatically reconciling the payables subsidiary ledger to the general

ledger.
E Generating exception and analytical reports.
System/Database Control Paper Document
Process EDI Transmission between application/systems

Approach: Enhancing Information Quality through a Data Govern-

ance Program
Identifies Information Requirements 377 Senior management establishes a data governance program to support the company’s
C
aptures Internal and External Sources objectives of ensuring reliability of information used in support of internal controls and
of Data external financial reporting. Senior management formalizes policies, procedures, and
responsibilities for data and information management considering the volume, complex-
ity, and demand for rapid capture and dissemination from multiple sources. The data
governance program includes policies and procedures for:
Considers Costs and Benefits
•• Assigning roles and responsibilities between a central data management group,
business functions, and IT
•• Validating sources of information
•• Establishing data-quality requirements before accepting sources into the informa-

tion system
•• Accessing rights to underlying data and related information produced

through processing

•• Protecting data during transmission and storage
Example: Validating Data and Information

378 RightChoice Pharmacy, Inc., a national drugstore retail chain, obtains significant data
underlying transactions recorded in point-of-sale systems located at each retail store.
Data underlying credit card transactions is sent immediately to the credit card company
and to RightChoice’s internal data warehouse. Daily reports are produced from the
data warehouse and used to prepare reconciliations of payments due from the credit
card companies.
379 The chief information officer and the credit and collections manager have designed
and implemented continuous transaction monitoring software to support their data and
information quality efforts. This software helps management to verify accounts receiv-
able balances each day and to avoid time-consuming month-end reconciliations by
quickly identifying data anomalies. Targeted data queries allow the software to identify
duplicate entries, unusual transactions, missing data, and incomplete data transfers.
Additionally, continuous monitoring software enables data analysis used to support
control activities to detect potential indicators of fraud.

Approach: Identifying, Protecting, and Retaining Financial Data

and Information
380 Senior IT management establishes policies to define categories of data and assign Identifies Information Requirements
requirements for physical handling, storage, security, and privacy. These policies C
support management and employee responsibilities for securing information from unau- of Data
thorized access or change and for adhering to retention requirements. The senior data • Processes Relevant Data into Information
administrator develops processes and repositories to carry out the data classification • Maintains Quality Throughout Processing
policy. Data classification requirements are communicated to personnel responsible for
• Considers Costs and Benefits
transaction processing through periodic reminders on important internal control respon-
sibilities. Important to this process is considering the benefits and costs to manage and
store information and the relative value of the information to the entity.
Example: Identifying and Protecting Financial Data and Information

381 Bio-Adaptive, Inc., a global life science and chemical manufacturer, has developed
standard operating procedures to identify, classify, and secure sensitive information,
including financial information, throughout the data and information life cycle (input,
processing, output, storage). These procedures include, but are not limited to:

•• Employees confirming adherence to standard operating procedures
•• Information being assigned to a data category, which is input into the

information system
•• Financial information being specifically identified for protection and retention in

order to meet reporting requirements
•• The information system automatically assigning the security, privacy, and storage
and retention requirements based on the data category input
•• Periodic reviews being performed to ensure that data has been properly classified
to improve security and reduce storage costs
Example: Identifying and Classifying Data for Financial Reporting

382 Freedom Corp., a financial services firm, has a process to tag financial data during
transaction processing based on criteria established in the company’s data classi-
fication policy. Business and IT personnel who are involved in detailed transactional
processing are trained in proper data entry to support accurate and complete classifi-
cation, tagging, storage, retention, and disposal.
383 This process reduces time required to format, organize, and report data. It also enables
the company to tag data through eXtensible Business Reporting Language (XBRL).
XBRL enables Freedom Financial to meet certain external financial reporting require-
ments and to perform comparative analyses to historical, competitor, and projected
financial data.

Communicates Internally
Principle 14. The organization internally communicates
information, including objectives and responsibilities for
internal control, necessary to support the functioning of
other components of internal control.
Points of Focus
•• Communicates Internal Control Information—A process is in place to communi-

cate required information to enable all personnel to understand and carry out their
internal control responsibilities.
•• Communicates with the Board of Directors—Communication exists between

management and the board of directors so that both have information needed to
fulfill their roles with respect to the entity’s objectives.
Draft for Discussion •• Provides Separate Communication Lines—Separate communication channels,

such as whistle-blower hotlines, are in place and serve as fail-safe mechanisms
to enable anonymous or confidential communication when normal channels are
inoperative or ineffective.
•• Selects Relevant Method of Communication—The method of communication

considers the timing, audience, and nature of the information.
Approach: Communicating Information Regarding External Finan-

cial Reporting Objectives and Internal Control
• C
ommunicates Internal Control 385 Senior management communicates information about the company’s financial reporting
Information objectives, financial control requirements, and internal control policies and procedures,
C
ommunicates with The Board and how they support individual responsibilities through a variety of communication
of Directors channels. The method of communication varies depending on the audience, the nature
Provides Separate Communication Lines of the information, time sensitivity, cost, legal or regulatory requirements, and ability to
use technology solutions. Such mechanisms may include:
• S elects Relevant Method of
Communication •• Departmental vision and mission objective signposts in high-traffic areas or on the
company’s website
•• Accounting and finance internal meetings or conferences to discuss internal

control matters and accounting policy changes
•• Periodic employee surveys related to awareness and compliance to internal

control policies and procedures

Information and Communication | Communicates Internally
•• An intranet site specific to internal control matters, including code of conduct,

roles and responsibilities, policies, procedures, and other relevant matters
•• Regular organization-wide emails, newsletters, conference calls, webcasts, or

meetings about updates on internal control matters
•• Senior finance and executive management visits to plants, sales offices, major
customers, and other locations
Example: Using Communications Programs to Reinforce

Internal Control
386 AtHome Corp. is a global home-building company. Both the CEO, Janis Wilcox, and
the CFO, Terry Tomlinson, use regular broadcast emails and personal visits to various
company sites to communicate with finance, accounting, and other personnel who
impact internal control over external financial reporting.
387 Mr. Tomlinson uses these mechanisms to reinforce company expectations for adher-
ence to internal control over external financial reporting, laws, and regulations; the
importance of the company’s internal audit function; and actions taken in response to

internal audit findings and internal control recommendations from its external auditors.
388 In turn, Ms. Wilcox finds the broadcast emails an effective means of sharing informa-
tion about the company’s business objectives and goals, including a periodic update
on progress toward those goals. She also visits the various corporate sites and meets
with employees and managers to ascertain how well they understand key business and
financial objectives relevant to their sites and to reinforce the messages about inter-
nal control from Mr. Tomlinson. Presentation material and supporting information and
intranet links are provided to the participants to support these communications.
Example: Using an Internal Accounting and Finance Conference to

Reinforce Policy Changes
389 NetComm, Inc., a broadband infrastructure company, holds a semi-annual meeting led
by the CFO and controller. The personnel from the finance department attend these
meetings to obtain updated information on significant new or changed matters that
impact finance activities and financial results. Meeting topics routinely include:
•• Key objectives for the next six months
•• Reinforcement of the company’s policies related to ethics and integrity
•• Expectations regarding recent findings from internal or external audits related to

financial reporting and control
•• Changes to the internal control structure
•• Significant recent or anticipated events such as the sale of a business, acquisition

of assets, restructuring of operations, or introduction of a new product
•• Changes to accounting policy and regulatory rules that would impact how
the company processes their financial transactions and produces their
financial reports

Approach: Communicating Internal Control Responsibilities

• C
ommunicates Internal Control 390 Documentation on internal controls related to financially significant business processes
Information and systems is stored in a shared repository that is accessible to management and per-
C
ommunicates with The Board sonnel who are responsible for external financial reporting. This repository contains:
of Directors
•• Risk assessment documentation
Provides Separate Communication Lines
• S elects Relevant Method of •• Business process documentation, including process flow diagrams and support-
Communication ing narratives
•• Internal controls identified by management based on risk assessments
•• List of individual internal controls, including assignment responsibility for perfor-

mance and review/approval to specified employees and management
391 The internal audit department reviews the information in the repository as part of its
ongoing and separate evaluations. Updates to specific internal controls are commu-
nicated to both the control performer and reviewer through email alerts with links to
the repository.
Example: Using Governance, Risk, and Compliance Technology to

Manage Internal Controls
392 A manufacturer of chemical and pharmaceutical products, Travis Pharma, has imple-
mented a governance, risk, and compliance technology solution. This provides the
CFO, Frances VanWyck, with a reporting tool to support her oversight of the system of
internal control over external financial reporting. Information communicated through the
tool includes:
•• External financial reporting objectives
•• Related external financial reporting risks
•• Internal controls
•• Evaluation approaches for each control
•• Responsibility for performance and review of each control
•• Evaluation results and action plans to address deviations
393 The reporting tool also provides a personalized dashboard; workflow process (for
performance or review, as appropriate); reporting capabilities for more detailed status,
issues, and trends; and other information to understand and manage the individual’s
internal control responsibilities.

Approach: Developing Guidelines for Communication to the Board

of Directors
394 The Board of Directors establishes a board charter that defines the guidelines for infor- C
ommunicates Internal Control
mation to be shared with the board of directors, responsibilities for communication, and Information
the method of communication. The charter specifies key guidelines, which may include: • C
ommunicates with The Board
of Directors
•• Frequency and number of board meetings, including committees of the board
•• Objectives of each board or committee meeting (e.g., strategy reviews, annual • S elects Relevant Method of
budgets, and plan reviews) Communication
•• Nature and extent of information to be shared for each meeting
•• Responsibility for preparing and approving minutes
Example: Facilitating Communication between Executive Manage-

ment and the Board of Directors
395 Fred Cummins, the general counsel of a printing company, EasySigns, Inc., under
the direction of the chair of the board, is responsible for coordinating all meetings of
the board of directors and board committees. He has implemented a straightforward

system to ensure timely and effective communication.
396 Fred reviews the annual calendar of audit committee meetings and the general agenda
for each meeting. He develops specific topics for discussion for each meeting relevant
to the company’s external financial reporting requirements and confirms the agenda
details with the CFO and audit committee chair. Based on the detailed agenda, Fred
gathers relevant information to be included in the audit committee meeting materi-
als that are sent to members one week prior to the meeting. From time to time, Fred
requests that members of management attend meetings to present information in
person and allow for active communication. For example, the CIO presents on the com-
pany’s security and privacy programs and new events that may impact risks.
397 Mr. Cummins also meets with the chair of the audit committee on an ad hoc basis to
review the results of recent audits, discuss changes to the internal audit plan, commu-
nicate issues or risks related to significant, time-sensitive transactions, or to update the
audit committee chair on significant issues, such as investigations of potential fraud.
Approach: Reviewing Financial and Internal Control Information

with the Board of Directors
398 At designated board meetings, the CFO and supporting personnel present finan- C
cial information; provide an analysis of the results compared with expectations; give Information
updates on forecasts and major changes to original budgets; and communicate other • C
matters of significance to financial reporting. of Directors
399 On a regular basis, the CEO, CFO, and the chief audit executive (CAE) present the
S elects Relevant Method of
draft external financial statements. Material events, changes in significant estimates,
Communication
or assumptions and significant new disclosure matters since the prior quarter are also
presented and discussed. The external auditors attend these meetings to present their
point of view on the financial statements.

400 At each quarterly meeting, the CFO, CAE, and the external auditor present a summary
of key changes in internal control, results of evaluations, and actions in response to any
deviations identified. Matters of significance are reported in writing. The audit com-
mittee holds separate private sessions with management and the external auditors.
These sessions provide the audit committee and either management or the auditors an
opportunity to share sensitive information and ask probing questions that facilitate each
party’s responsibilities related to internal control.
Example: Preparing Financial and Internal Control Reporting Pack-

age for Discussion with the Board
401 The senior financial management at a privately held mining company, Precious Metals
Corp., has developed a financial and internal control reporting package for the board
meeting. The package has been developed from both quantitative and qualitative finan-
cial reporting and internal control information. It highlights financial and internal control
trends and internal control matters requiring the board’s attention, such as significant,
non-recurring adjustments and internal control deficiencies by each financial statement
line item for each of the last four quarters. Other information in the package includes:
•• Dollar impact of adjustments

•• Estimated impact of deficiencies after considering compensating controls
•• Brief description of severity of issues, business function, and

process(es) impacted
•• Management point of contact and action plan
•• Changes in accounting policies
•• New regulatory requirements
•• Significant changes in financial statements and disclosures
402 The management team sends the package to the board in advance of the meeting to
allow board members to review and follow up with management in preparation of the
meeting, if necessary.
Approach: Communicating a Whistle-Blower Program to

Company Personnel
C
ommunicates Internal Control 403 Management and the board establish a whistle-blower program for employees to use a
Information hotline to communicate concerns, instances of perceived misconduct, matters relat-
• C
ommunicates with The Board ing to external financial reporting, or other significant matters that may impact internal
of Directors control. To enhance employee awareness of the program, a number of communication
• Provides Separate Communication Lines channels are used. These include postings in high-traffic areas in offices and periodic
messages from the director of human resources.
Communication
404 The program allows employees who report matters through the hotline to remain
anonymous, and all communication is completely confidential. Reported matters are
evaluated by an objective party and communicated to the board of directors or, where
appropriate, a specified delegate.

Example: Employee Ethics Hotline

405 General Goods Packaging has established a toll-free hotline for employees to report
misconduct. The hotline is described in the employee handbook and on the company
intranet. Information is also posted at various high-traffic locations in the company’s
facilities, such as the cafeteria, coffee room, restrooms, and main entrance.
406 The hotline is administered by a third party. All matters received on the line are catego-
rized, summarized, and reported to a separate compliance department that reports to
internal audit. The director of compliance then reviews and prioritizes all reports.
407 Those matters of significance or heightened sensitivity are reported immediately to the
CFO and the chair of the audit committee. Others are investigated based on their prior-
ity. The CFO and members of the executive management team review the results of all
investigations and recommend what actions should be taken.
408 Information about each reported matter, including evidence gathered, actions taken,
and conclusions reached, is documented in a separate, confidential section of the
hotline system.

409
Approach: Communicating through Alternative Reporting Channels
Management provides an alternative to reporting to a line manager so that employees
are confident that they will be heard. Alternative reporting and communications chan-
nels may include:
C
Information
C
of Directors
• Provides Separate Communication Lines
•• Mentoring programs to provide employees with a support structure beyond their
direct line manager
Communication
•• Town hall meetings where employees are encouraged to ask questions and
discuss their concerns
•• A staff council comprising employees from various departments and various

levels below manager which meets to discuss various issues and relays com-
ments and observations to management
Example: Establishing a Mentoring Program to Encourage Commu-

nicating with Management
410 Odette Group, a designer and distributor of sports apparel, has established a suc-
cessful mentoring program for its employees. Every employee is assigned an individual
“coach,” who is selected from management of a different department. The employee
and coach meet quarterly, or as needed, to discuss topics such as the employee’s long-
term goals, areas of interest for growth and development, and results of periodic perfor-
mance reviews. At these meetings, coaches encourage employees to provide feedback
on any issues or concerns for which they did not see a clear communication channel.
411 As an added measure, all staff involved in the financial reporting process is assigned a
mentor with financial reporting and internal control experience. This provides an alterna-
tive to the employee’s line supervisor for discussing and reporting concerns on matters
such as compensation, operations, or internal controls.

Approach: Establishing Cross-Functional and Multidirectional Inter-

• C
ommunicates Internal Control nal Control Communication Processes and Forums
Information
412 Management from all departments develop cross-functional and departmental commu-
C
nication processes and forums that enable personnel to communicate internal control
of Directors
matters across the entity. Representatives from each department have defined roles
• Provides Separate Communication Lines
and responsibilities for communicating internal control matters using these processes
S elects Relevant Method of and forums. The group meets periodically to discuss issues, trends, and upcoming
Communication events that impact internal controls. Control matters and issues noted by a shared
service center, business unit, or department are communicated to the other depart-
ments and business units. Management and personnel in the departments and busi-
ness units evaluate and respond to the impact of these matters and issues.
Example: Establishing a Cross-Functional Internal

Control Committee
413 Sea to Sky Telecommunications has established an internal control council comprising
functional and IT business process owners from each business unit, corporate account-
ing, shared service center, and internal audit. The council meets monthly to define
information that should be shared among business units and that may impact company

processes. Topics raised at these meetings include:
•• Incidents of fraud in one department that may impact other departments
•• Changes to systems that have a cross-functional impact on processes

and controls
•• Changes to regulations that impact how different departments exchange

information
•• Internal and external audit findings
414 The representatives on the council review all matters raised to consider how they
impact the various departments of Sea to Sky. Council members take turns recording
the meeting proceedings, which are reviewed by all council members and then shared
with the CFO.

Information and Communication | Communicates Externally
Communicates Externally
Principle 15. The organization communicates with external
parties regarding matters affecting the functioning of
other components of internal control.
Points of Focus
•• Communicates to External Parties—Processes are in place to communicate rel-

evant and timely information to external parties, including shareholders, partners,
owners, regulators, customers, and financial analysts and other external parties.
•• Enables Inbound Communications—Open communication channels allow input

from customers, consumers, suppliers, external auditors, regulators, financial
analysts, and others, providing management and the board of directors with rel-
evant information.

•• Communicates with the Board of Directors—Relevant information resulting
from assessments conducted by external parties is communicated to the board
of directors.
•• Provides Separate Communication Lines—Separate communications channels,

such as whistle-blower hotlines, are in place and serve as fail-safe mechanisms
to enable anonymous or confidential communication when normal channels are
inoperative or ineffective.
•• Selects Relevant Method of Communication—The method of communication

considers the timing, audience, nature of the communication, and legal, regula-
tory, and fiduciary requirements and expectations.

Approaches to Applying the Principle
Approach: Communicating Information to Relevant External Parties

• Communicates to External Parties 416 Management considers all relevant external parties who have an interest in or who
Enables Inbound Communications would be reasonably expected to obtain information about the company’s internal
control over external financial reporting. The company’s disclosure committee (or similar
Communicates with The Board of Directors
group responsible for external communications) has established a process to evaluate
ongoing company events, policies, activities, and other matters that impact external
Selects Relevant Method of Communication parties that are important to the company’s external financial reporting objectives. The
disclosure committee determines the information that should be reported to external
parties, as needed. Such information may include:
•• Internal controls over transactions and balances that represent significant pay-
ables, receivables, or commitments to external stakeholders
•• Results of procedures for monitoring compliance with contractual commitments

and related loss or damages provisions
•• Policies for protecting information received from external parties during normal

business transactions
•• Customer responsibilities for managing their employees’ access to the company’s

web-based ordering system to prevent unauthorized orders
•• Policies related to performing background checks and credit checks, or using col-
lection agencies
Example: Communicating Internal Control Information to Oversee a

Federal Agency
417 A federal agency is responsible for managing payments of approved funds to not-for-
profit organizations that provide community outreach programs for underprivileged chil-
dren. The agency is one of several that support similar programs in other communities
and is overseen by an external organization. In connection with its oversight responsi-
bilities, the federal agency requests information from each community program about
the program’s controls over the allocation and distribution of funds received.
418 Management of each program summarizes controls over the allocation and distribution
of funds that have been implemented and a statement from management that it has
confirmed that the controls were operating for the quarter. Any changes to or dete-
rioration in the controls, such as changes in ability to segregate duties due to loss of
personnel, are communicated along with management’s actions to mitigate risks. This
summary is provided quarterly to the oversight agency.
Example: Establishing Periodic Communications with Contractors

and Outsourced Service Providers
419 ConFab Group, a large, privately held telecommunications equipment provider, out-
sources all of its manufacturing activities to third parties, which are located around the
world. Under the contractual arrangements, ConFab is responsible for damage or loss
of inventory from the receipt of raw materials at the third-party contract manufacturer

until the completed products are delivered to the freight forwarder for shipment.
This means management retains significant risk to inventory that is not within its
physical control.
420 ConFab’s management team has specific policies and procedures for the purchasing,
manufacture, and preparation of shipments to mitigate its economic exposure and that
support its estimates for inventory reserves. Management communicates these policies
to the manufacturers, along with specific contract clauses that require adherence to the
policies and the right to audit by the company.
421 To ensure that policies and procedures are carried out as intended, ConFab has imple-
mented several methods of communicating with the contract manufacturers:
•• A website built specifically for communications between the company and the
contract manufacturers
•• A link on the company’s website to policies and procedures, which contrac-

tors are required to acknowledge they have read, understood, and to which they
will adhere
•• A variety of periodic reports from the contract manufacturers, which are used in

company control activities to ensure that inventory balances and related estimates
are properly reported
•• Periodic on-site audits at contract manufacturers to validate the inventory quanti-

ties on hand, stage of production, and quality. The audits include random inter-
views of personnel to confirm their understanding and adherence to policies and
procedures and inspection of inventory transactions, documents, and reports.
422 ConFab also performs annual reviews of the contract manufacturers’ controls that
support the completeness and accuracy of reports provided throughout the year.
Approach: Obtaining Information from Outside Sources

423 Management and other personnel stay abreast of new matters relevant to their area of Communicates to External Parties
responsibility in order to identify and respond to changes that may impact, directly or • Enables Inbound Communications
indirectly, external financial reporting objectives or the related internal control. Manage- Communicates with The Board of Directors
ment of each business unit or functional group identifies relevant means to receive infor-
mation from outside the company, and assigns responsibility to themselves and other
personnel to be responsible for obtaining, reviewing, and sharing relevant information Selects Relevant Method of Communication
within the company, as appropriate. Sources of information may include:
•• Publications that provide updates to financial accounting, reporting, and disclo-

sure standards or regulations
•• Technical journals that analyze the impact of financial accounting and

reporting matters
•• Competitor or peer regulatory filings
•• Information gathered at industry or trade association meetings

•• Industry, market, economic, or competitor data relevant to key metrics or

accounting estimates
•• Alerts from outside counsel on regulatory or legal changes
•• Periodic meetings with external auditors and advisors to understand new

accounting and disclosure requirements
•• Meetings with outside advisors or subject matter specialists with the expertise to
assess complex accounting and disclosures for major transactions or events
•• Standard-setter and regulator projects and publications
•• Postings on organization-sponsored or supported social media websites or com-

munication tool.
Example: Communications from Regulatory Bodies

424 As a result of a regulator’s examination, Norgaard-Kellogg Financial, a registered invest-
ment advisor, was informed that the firm was not in compliance with rules requiring
documentation of certain compliance policies and procedures for trading activities and
the related accounting and disclosure requirements. Eileen Nachbar, the company CFO,

met with outside counsel and external auditors to review the matters and obtain their
views. She also engaged other external advisors with expertise on risks and best prac-
tice procedures related to trading activities.
425 After these discussions, Ms. Nachbar met with the senior management of Norgaard-
Kellogg responsible for trading activities to discuss the regulator’s findings and her
own evaluation of the issue and recommendations for enhancements. The informa-
tion was shared with the disclosure committee, a group responsible for assessing
the requirements for disclosures in external filings. After approval of the proposed
actions by the disclosure committee, Ms. Nachbar developed an action plan for updat-
ing internal control policies, procedures, and related documentation to address the
compliance requirements.
Example: Obtaining Information from External Sources to Assist

with Accounting Estimates
426 Nevio Group regularly sells its products in highly unstable economic environments
where currency values fluctuate significantly. These fluctuations significantly affect the
accounting treatment of transactions and balances recorded in the financial statements.
427 Clint Bell, the assistant treasurer, is responsible for obtaining and analyzing informa-
tion from an outside advisory firm related to the past, present, and future expectations
of currency fluctuations. One of his sources is a subscription service that provides
reporting on currency values, changes in values, and trends over periods of time. It also
provides alerts if currency fluctuations exceed certain thresholds.
428 Mr. Bell sets up the relevant currencies, time periods, and alerts appropriate for Nevio
Group. The treasurer reviews the settings and approves changes, if needed, each
quarter. On a monthly basis, or more frequently based on alerts received, Mr. Bell evalu-
ates the currency rates used for financial accounting associated with significant esti-
mates impacted by currency values.

429 Based on the information gathered and corroborated from various external sources, he
updates his analysis estimates. The analysis is given to the treasurer, director of finan-
cial reporting, and controller to help them ensure that the basis for their estimates and
communications in external reports are current and appropriate.
Approach: Surveying External Parties
430 Management surveys customers, vendors, and others on their perception of the integ- Communicates to External Parties
rity and ethical values of company personnel. This survey process is controlled by • Enables Inbound Communications
company personnel independent of the main customer/vendor contacts. These surveys
not only provide a sounding board for the company’s customers, but also enable man-
agement to gain important information about the commitments made to customers and • Provides Separate Communication Lines
ensure that such commitments are consistent with the understanding of formal arrange- Selects Relevant Method of Communication
ments between parties.
431 Management carries out surveys of external parties in a variety of ways, which
may include:

•• Periodic surveys with standard questions regarding the company and its products
or services sent to all customers
•• Providing a feedback mechanism on the company’s website or through a feed-

back box on documents that are sent regularly to external parties
•• Periodically meeting with external parties, in person or by video or teleconference
Example: Conducting Discussions with Customers

432 Fitness Four, a manufacturer of strength and cardiovascular fitness equipment, has
developed a policy requiring that each customer be contacted by a member of man-
agement at least annually. The management team member must not be the customer’s
primary contact or in any senior line of reporting of the customer’s primary contact at
the company.
433 During these discussions with customers, the manager is expected to address a
number of areas relevant to the customer-company relationship that impact external
financial reporting, including:
•• Customers’ adherence to acceptable use provisions based on licensing rights that

may impact royalty costs
•• Confirmation of continued use of products or services that may impact the esti-
mated life of assets or term of contracts used for accounting judgments
•• Issues, concerns, or return activity of company products that may indicate that
recorded sales transactions were not valid
•• Feedback on company individuals that the customer interacts with during the
sales, delivery, support, customer service, or billing process
•• Any regulatory, compliance, or internal customer policy requirements that should

be considered in the manufacture of products or provision of services

•• Expectations of the customer for additional products, services, or support

that may indicate commitments made outside of the contracts or other
written arrangements
434 The information gathered through these conversations is shared with finance and other
relevant company personnel. Any issues that indicate a potential financial reporting
issue, such as incomplete delivery of products or services, or billing and payment,
issues are further investigated. Where changes in the accounting for transactions are
needed, additional reviews are performed to ensure that the issues are fully resolved.
Also, an evaluation of internal controls for deficiencies is conducted to prevent or detect
Approach: Communicating the Whistle-Blower Program to

Outside Parties
• Communicates to External Parties 435 Management provides a whistle-blower phone number or email address available to
customers, suppliers, outsourcing companies, and other external parties to facilitate
• Enables Inbound Communications
feedback on potential improprieties or improper or unreliable financial reporting. The
contact information is disseminated through various means, such as the company’s

• Provides Separate Communication Lines website and on invoices sent to customers.
Selects Relevant Method of Communication
Example: Facilitating Communication with External Parties
436 Shoreup Nutrients is a manufacturer and retailer of branded and private label vitamins
and nutritional supplements. It provides a section on its website for anyone who wants
to respond with questions, concerns, complaints, or other information.
437 The internal audit department of Shoreup Nutrients is responsible for maintaining a
process to ensure that all reported matters are collected, documented, evaluated, and
addressed appropriately. On a weekly basis, internal audit monitors the website and
summarizes any new information collected by using a collaboration software tool acces-
sible only to the audit department.
438 The director of internal audit, Naseema Bahair, evaluates each matter and develops an
action plan, which includes:
•• Conducting interviews of company personnel
•• Obtaining and reviewing relevant documentation
•• Contacting the reporting party for additional information, if necessary.
439 Upon review of complaints received through whistle-blower hotlines, a decision is made
by the CFO or the audit committee chair about the information that will be shared to the
reporting party.

Approach: Reviewing External Audit Communications

440 Following the external auditor’s review of financial information and independent evalua- Communicates to External Parties
tion of internal control effectiveness, management receives a written summary of signifi- • Enables Inbound Communications
cant matters identified during the course of the work. The board of directors discusses
• Communicates with The Board of Directors
these at a subsequent meeting, where external audit personnel discuss their findings
and management discusses proposed resolutions.
Selects Relevant Method of Communication
Example: Managing and Assessing External Audit Communications

441 The management at Hessen’s Assure, a healthcare insurance company, has established
a process with the external audit firm to coordinate the periodic assessments of inter-
nal controls and discuss and respond to matters identified during the course of exter-
nal audit reviews. The management team meets monthly with the external auditor to
discuss internal control testing plans, status, and issues.
442 Internal control issues or recommendations for improvement that are identified by the
external audit firm are assigned to an employee in the impacted business process
area, and that person develops and presents a recommended response at the monthly
meeting, or more frequently if needed. The management team evaluates each response,

such as modifying internal control activities; reinforcing awareness; updating policy,
procedure, or control documentation; or performing additional evaluations, and assigns
responsibility for carrying out the response.
443 Results of the management meeting are communicated to the external audit firm. As
well, a summary of significant issues and observations are presented at the audit com-
mittee meeting at set intervals during the year or as necessary.


Components of Internal Control | Monitoring Activities
6. Monitoring Activities
Chapter Summary
444 Ongoing evaluations, separate evaluations, or some combination of
the two are used to ascertain whether each of the five components of
internal control, including controls to effect the principles within each
component, is present and functioning. Ongoing evaluations, built into
business processes at different levels of the entity, provide timely infor-
mation. Separate evaluations, conducted periodically, will vary in scope
and frequency depending on assessment of risks, effectiveness of on-
going evaluations, and other management considerations. Findings are
evaluated against criteria established by regulators, standard-setting

bodies or management’s criteria, and deficiencies are communicated to
management and the board of directors as appropriate.
Principles relating to the Monitoring Activities Component
16. The organization selects, develops, and performs ongoing and/

or separate evaluations to ascertain whether the components of
internal control are present and functioning.
17. The organization evaluates and communicates internal control

deficiencies in a timely manner to those parties responsible for
taking corrective action, including senior management and the
board of directors, as appropriate.

Principles Possible Approaches
16. The organization selects, devel- •• Periodically Reviewing the Mix of

ops, and performs ongoing and/or Monitoring Activities
separate evaluations to ascertain
•• Establishing a Baseline
whether the components of internal
control are present and functioning. •• Identifying and Using Metrics
•• Designing and Implementing a

Dashboard
•• Using Technology to Support Moni-

toring Activities
•• Conducting Separate Evaluations
•• Using Internal Audit to Conduct Sepa-

rate Evaluations
•• Understanding Controls at an Out-

sourced Service Provider

17. The organization evaluates and com- •• Assessing and Reporting Deficiencies
municates internal control deficien-
•• Monitoring Corrective Action
cies in a timely manner to those
parties responsible for taking cor- •• Developing Guidelines for Reporting
rective action, including senior man- Deficiencies
agement and the board of directors,
as appropriate.

Monitoring Activities | Conducts Ongoing and/or Separate Evaluations
Conducts Ongoing and/or Separate Evaluations

Principle 16. The organization selects, develops, and
performs ongoing and/or separate evaluations to
ascertain whether the components of internal control are
present and functioning.
Points of Focus
•• Considers a Mix of Ongoing and Separate Evaluations—Management includes a

balance of ongoing and separate evaluations.
•• Considers Rate of Change—Management considers the rate of change in busi-

ness and business processes when selecting and developing ongoing and sepa-
rate evaluations.

•• Establishes Baseline Understanding—The design and current state of an
internal control system are used to establish a baseline for ongoing and
separate evaluations.
•• Uses Knowledgeable Personnel—Evaluators who perform ongoing and separate

evaluations have sufficient knowledge to understand what is being evaluated.
•• Integrates with Business Processes—Ongoing evaluations are built into the busi-
ness processes and adjust to changing conditions.
•• Adjusts Scope and Frequency—Management varies the scope and frequency of

separate evaluations depending on risk.
•• Objectively Evaluates—Separate evaluations are performed periodically to

provide objective feedback.

Approach: Periodically Reviewing the Mix of Monitoring Activities

• Considers a Mix of Ongoing and 446 Senior management meets periodically to review the allocation of effort between
Separate Evaluations ongoing evaluations and separate evaluations used to conduct monitoring activities.
• Considers Rate of Change The mix of planned monitoring activities over internal control of external financial report-
Establishes Baseline Understanding ing may depend on senior management’s assessment of:
Uses Knowledgeable Personnel •• The entity’s regulatory requirements and financial reporting objectives
Integrates with Business Processes •• How quickly the entity’s industry and/or regulatory environment is changing or
• Adjusts Scope and Frequency anticipated to change
Objectively Evaluates
•• The results of historical evaluations of control effectiveness
•• The extent of ongoing monitoring within the associated processes
•• Changes that have occurred in the current year that impact other components of
internal control
447 Senior management may also increase the frequency of separate evaluations from the

initial plan in processes where:
•• Existing monitoring activities raise potential deficiencies in the system of

internal control
•• Key performance indicators, which correlate to surfacing potential deficiencies in

internal control, have exceeded a prescribed threshold
Example: Changes in Business Operations

448 Hunter Manufacturing has thirteen different plant locations, six of which are considered
significant. The management team of Hunter Manufacturing has been monitoring the
internal control in the seven smaller, less significant plants, primarily through ongoing
evaluations. However, management has now determined that some separate evalua-
tions have become necessary. This decision has been made due to the increase in risk
factors at these plants, including frequent errors in monthly and quarterly reconcilia-
tion activities and turnover among plant-level controllers and supervisory personnel.
Accordingly, management has now implemented random plant audits to periodically
evaluate controls.
Example: Changing the Internal Audit Plan

449 Viliam Financial Services is a publicly held global company. Recently the industry has
experienced a significant rate of change because of increasing regulatory focus and
complexity of the company’s financial products. In response to these changes, Viliam’s
management and board of directors have reprioritized the activities conducted by its
internal audit department, including:
•• More active oversight of Viliam’s recently enhanced risk management and gover-
nance processes

•• An iterative risk assessment process that performs a risk review annually and
more often if the business changes
•• Reviews of financial and operational data to identify risks and adverse trends, and
to respond to them accordingly by conducting targeted audits
Approach: Establishing a Baseline

450 Senior management develops a baseline understanding of the design and current state Considers a Mix of Ongoing and
of the entity’s system of internal control by: Separate Evaluations
Considers Rate of Change
•• Determining the starting point of the system
• Establishes Baseline Understanding
•• Reviewing if controls are operating as intended to achieve an entity’s objectives
Uses Knowledgeable Personnel
451 Management then leverages the established baseline to: Integrates with Business Processes
•• Identify necessary changes in design and conduct of internal controls that result Adjusts Scope and Frequency
from monitoring activities Objectively Evaluates

•• Evaluate changes in people, processes, and technology that may impact the
design and implementation of controls
•• Establish a new baseline that incorporates any changes that impact the
previous baseline
452 Senior management may use the baseline information to establish which ongoing and
separate evaluations are most appropriate.
Example: Establishing a Baseline

453 The senior management of Judd Co., a beverage manufacturer and distributor, focuses
the organization’s monitoring efforts by risk priority. In areas of meaningful risks the
entity conducts and documents a thorough review of the design and operation of
controls to establish a baseline. With risks prioritized and the baseline established,
management identifies monitoring activities that can identify changes to the system of
internal control in a reasonable period of time. The baseline aids Judd Co. in selecting
more efficient monitoring activities, such as self-assessments coupled with supervisory
review. Then, at intervals appropriate to the level of risk, internal audit performs periodic
separate evaluations to reconfirm the system of internal control against the baseline and
the effectiveness of the ongoing monitoring procedures.

Approach: Identifying and Using Metrics15

Considers a Mix of Ongoing and 454 Management identifies metrics that correlate to the completeness and accuracy of
Separate Evaluations financial transactions to provide ongoing evaluations of established control activities.
Considers Rate of Change When identifying metrics, management considers the processes and sub-processes
• Establishes Baseline Understanding that should be monitored, and develops the appropriate measure and frequency for
the evaluation.
• Integrates with Business Processes 455 The metrics may use the following information:
Adjusts Scope and Frequency
•• Historical performance data, which may be useful for comparisons to current
Objectively Evaluates performance data
•• Expected performance targets, which may be used to benchmark current perfor-

mance against expected performance
456 Some metrics have clearly defined allowable tolerances that have been calculated for
current performance data, which may be used to highlight anomalies. Other metrics
have less defined thresholds and are reviewed by knowledgeable employees for reason-
ableness and unusual items.

Example: Using Metrics to Monitor Payroll
457 Approximately 90% of Mynarski Manufacturing employees are located at company
plant sites. To monitor whether the payroll processing control activities are working,
Henrik Saunders, the corporate payroll manager, reviews the plant payroll metrics.
Payroll metrics include:
•• Current head count compared with expected and historical head count for the
month, quarter, and year
•• Current payroll compared with expected and historical payroll for the month,
quarter, and year
•• Current overtime in hours and dollars compared with expected and historical
overtime in hours and dollars for the month, quarter and year.
458 In his review, Mr. Saunders looks for any unusual fluctuations, such as increases and
decreases in the number of employees and excessive overtime. His review is done in
the context of current plant productivity and target thresholds based on historical data
and planned productivity, which varies by season. If Mr. Saunders identifies any fluctua-
tions, he investigates the underlying reasons and adjusts the process or control activi-
ties as needed.
15 Metrics, often operational in nature, may use information that indirectly signals a failure or anomaly, but
there may be other information available more directly linked to changes or failures. The value of metrics
should be considered when an entity evaluates what mix of ongoing and separate evaluations is appropri-
ate for that entity.

Example: Using Built-In Operating Measures and Key

Control Indicators
459 Tony Rosco is the controller Still Craft Foods. He uses operating measures and key
performance indicators (KPIs) for major accounting and financial processes, including
accounts receivable, payroll, accounts payable, and financial statement preparation.
Accounts payable KPIs, for example, focus on the accuracy, timeliness, completeness,
and compliance of documents received for vouching and checks prepared, with perfor-
mance tracked to established targets.
460 Mr. Rosco leverages his knowledge of changes in the business when developing
his expectations on how performance is likely to be consistent with, or vary from,
established targets. In the case of accounts payable KPIs, those variances from the
established targets could result from known factors, such as significant new vendors,
changes in payment terms, and cash flow goals. Where results do not meet expecta-
tions, Mr. Rosco evaluates them for potential underlying issues in established control
activities. Additionally he uses the KPIs to identify trends that could indicate some
fraudulent activity (e.g., he sees a concentration of payments to a vendor that is new or
for which he would not expect that volume).

461 He shares his findings with the management team, which uses the information in perfor-
mance appraisals and related development programs.
Approach: Designing and Implementing a Dashboard16

462 As part of its ongoing evaluations, management develops and implements dashboards Considers a Mix of Ongoing and
Separate Evaluations
for reviewers to use in the ordinary course of business. Reviewers are usually supervi-
sors of those employees with first-level knowledge and who are accountable for pro- Considers Rate of Change
cesses, activities, and their controls. Dashboards may include: Establishes Baseline Understanding
•• Detailed and/or summarized information about control performance • Uses Knowledgeable Personnel
• Integrates with Business Processes
•• Metrics being measured and/or information being highlighted for evaluation and
Adjusts Scope and Frequency
investigative follow-up
•• Visual depictions of the status of control operation
•• Details of status including frequency of assessment and last assessment
•• Known current deficiencies and their remediation status
•• Key personnel and contact details for those responsible for processes and
sub-processes
16 Dashboards, often operational in nature, may use information that indirectly signals a failure or anomaly,
but there may be other information available more directly linked to changes or failures. The value of
metrics should be considered when an entity evaluates what mix of ongoing and separate evaluations is
appropriate for that entity.

Example: Using Dashboards to Relate Operating Information

463 Langdale Manufacturing, a manufacturer of industrial machinery parts, uses a set of
operating dashboards by business process, with each dashboard containing a series of
tasks assigned to the appropriate managers for action. The dashboard for the produc-
tion inventory process, for example, includes costs associated with tooling: where the
warehouse manager checks the usage of tools during production noting how often they
are needed, who requested them, and where they are purchased from.
464 Management then considers this information when reviewing tooling costs included in
inventory. In the monthly management meetings, these dashboards are reviewed. Each
of the managers responsible for specific tasks discusses recent progress and expected
changes over the coming month. To the extent that an increase in tool usage was noted,
management would expect that costs related to tooling would be up for the period.
Approach: Using Technology to Support Monitoring Activities17

Considers a Mix of Ongoing and 465 Management uses technology to support the monitoring of the system of internal

Separate Evaluations controls in the ordinary course of business through automated monitoring applications.
Considers Rate of Change Management uses the automated monitoring application to efficiently and continuously
Establishes Baseline Understanding review large volumes of data at a low cost with a high standard of objectivity (once pro-
grammed and tested). Automated monitoring activities may include:
• Integrates with Business Processes •• Checking transactions against predefined thresholds for anomalies
Adjusts Scope and Frequency •• Monitoring transactions for trends or patterns
•• Assessing automated performance indicators, metrics, and measures that may
lead to improvements in process and business
Example: Using Continuous Monitoring

466 Gentoo Financial Services employs a continuous monitoring tool to perform a simple
regression analysis of nonperforming loans by branch and by loan officers as one form
of monitoring control over loan origination. The output from the tool allows Gentoo to
look for outliers across multiple dimensions (e.g., policy, industry standards, and statis-
tical standard deviations). Further, the report can be repopulated in either real-time or
batch mode. This analysis helps Gentoo identify loan officers and/or branches that may
not be following loan origination policies.
Example: Using Technology to Identify Trends

467 Penguin Ice, a manufacturer of ice cream, uses an automated computer application as
part of its ongoing monitoring activities. One of the application’s activities identifies any
trends in the processing of journal entries of personnel who consistently approve entries
just below their authorization limit. Management then considers this information in
monthly meetings to determine if any fraud is occurring or if journal entry control activi-
ties for authorization limits need to be changed.
17 Note that many automated activities used to prevent or detect unintended events or results would be
considered control activities.

Approach: Conducting Separate Evaluations

468 Management may conduct separate evaluations of internal controls over external finan- • Considers a Mix of Ongoing and
cial reporting by: Separate Evaluations
Considers Rate of Change
•• Conducting ad hoc supervisory management visits and reviews
Establishes Baseline Understanding
•• Conducting cross operating unit reviews using management from similar operat-
• Uses Knowledgeable Personnel
ing units within the company
Integrates with Business Processes
•• Comparing components of internal control with another similar entity Adjusts Scope and Frequency
•• Developing a self-assessment questionnaire for a business process for use by • Objectively Evaluates
personnel responsible for the controls within a particular business unit or function.
Example: Conducting Senior Financial Officer Visits

469 Gregson Grenville is a publicly held consumer products company with multiple manu-
facturing facilities throughout the world. Every year, the company’s senior financial
officers for each division visit each subsidiary’s headquarters, manufacturing site, and/
or sales office to gain an understanding of significant business processes at those loca-
tions. During these visits, the senior financial officer discusses procedures and controls

for all relevant processes impacting financial reporting with those performing the control
activities and their supervisors. In addition, a mini-audit of select control activities is
also conducted, the findings are documented, and the local team develops manage-
ment actions plans for all pertinent recommendations. In addition, findings are shared
broadly throughout the organization to facilitate control enhancements at other loca-
tions, and areas of concern impact the focus of future senior officer visits at this and
other locations.
Example: Using Self-Assessments

470 Jaron and Associates provides Internet-based securities brokerage and financial ser-
vices. Recently the company instituted a formal internal control assessment program
(ICAP). Under this program, managers of each business unit perform a quarterly
control self-assessment and certify the effectiveness of certain controls for which they
are responsible.
471 The senior management of Jaron recognizes that self-assessment, while not completely
objective, is an effective first line of defense against internal control failure. Internal audit
helps compensate for the lack of objectivity in the control self-assessments by perform-
ing periodic audits and comparing the results to the self-assessments.
472 ICAP allows management to concentrate its ongoing evaluation efforts on

several issues:
•• Areas of higher risk (absence of self-assessments would dilute monitoring efforts

to include lower-risk areas)
•• Areas where ICAP has identified potential problems

•• Areas where separate evaluations have identified control deficiencies that were
not reported through the self-assessments
473 Now Jaron and Associates is better able to focus its separate evaluation efforts on a
prioritized-risk basis and modify ongoing evaluations where necessary.
Approach: Using Internal Audit to Conduct Separate Evaluations

• Considers a Mix of Ongoing and 474 Management uses an appropriately staffed and adequately trained internal audit func-
Separate Evaluations tion to provide an objective perspective on key elements of the internal control over
Considers Rate of Change external financial reporting. Internal audit reports are distributed to senior management,
Establishes Baseline Understanding the board of directors, and others who are positioned to act on the report’s recommen-
dations. Internal audit’s separate evaluations may be influenced by:
• Uses Knowledgeable Personnel
Integrates with Business Processes •• The entity’s regulatory environment and management’s methodology and plans
Adjusts Scope and Frequency for achieving compliance with its financial reporting objective
• Objectively Evaluates •• An understanding, independent of management, of how the internal control

system addresses meaningful risks

•• Approval for the planned separate evaluation activities by the board of directors or
one of its committees
Example: Conducting Separate Evaluations

475 Lee-Basker Parts designs, manufacturers, and distributes precision components and
assemblies for aerospace applications. From time to time the board directs the com-
pany’s internal audit department to perform separate evaluations of specified high-
risk business processes that impact the entity’s financial statements. The scope and
frequency of these evaluations depend primarily on the significance of the related risks
and importance of the controls in reducing risks to an acceptable level.
476 Subsequent to management’s input, it is up to the chief audit executive, Maria Geide, to
determine whether the internal audit department adequately understands the process,
the overall internal control structure, and the objectives of the review.
477 Once the review is complete, Ms. Geide submits a report on the process controls to
senior management and the board covering the scope of the work (including identifi-
cation of the controls evaluated), a description of the major risks and the appropriate-
ness of the controls, a list of identified deficiencies, and management’s response and
proposed remediation.

Approach: Understanding Controls at an Outsourced

Service Provider18
478 Management obtains and reviews periodic information from outsourced service provid- Considers a Mix of Ongoing and
ers to detect any changes in activities that impact the entity’s system of internal control Separate Evaluations
over external financial reporting. Information obtained may include: Considers Rate of Change
•• The outsourced service provider’s applicable control objectives Establishes Baseline Understanding
•• Details about which of the outsourced service provider’s internal control have
Integrates with Business Processes
been examined and included in any report
• Adjusts Scope and Frequency
•• The details and results from any independent audit testing performed
• Objectively Evaluates
•• Special considerations for the outsourced service provider that impacts the report
479 To determine what impact any identified changes may have on the entity’s system of
internal control over external financial reporting, the following may also be assessed:
•• Whether management appropriately considered known changes in business pro-

cesses and their impact on internal control, and whether they were communicated
to the outsourced service provider, since such changes could impact the entity’s

control objectives and design
•• Whether exceptions were noted that may trigger further review by senior
management
•• Whether management is satisfied with the independence and objectivity of

the report
480 Based on management’s review and findings, it may be necessary to reassess the
separate evaluation activities over the outsourced service provider.
Example: Reviewing the Service Auditor’s Report for Changes

in Controls
481 Finlayson Home Works supplies materials used in residential construction. This public
entity has outsourced its payroll activities for a number of years to a reputable payroll
services provider. The chief audit executive, Rolf Brunner, obtains an annual service
auditor’s report detailing the internal controls at the service provider. Mr. Brunner then
compares the current report to past reports to determine whether there have been
any changes in relevant controls that could impact the judgments made on planned
monitoring activities over the payroll process. The current report indicates some key
changes in the payroll service provider’s software and several negative test results in
priority risk areas. As a result, Mr. Brunner has the internal audit department of Finlay-
son Home Works perform a reconciliation of the payroll service provider’s processing
results to evaluate if additional separate evaluations of the payroll service provider may
be necessary.
18 The review of controls at the outsourced service provider is covered in Chapter 3, Control Activities.

Evaluates and Communicates Deficiencies

Principle 17. The organization evaluates and
communicates internal control deficiencies in a timely
manner to those parties responsible for taking corrective
action, including senior management and the board of
directors,19 as appropriate.
Points of Focus
•• Assesses Results—Management and the board of directors, as appropriate,

assess results of ongoing and separate evaluations.
•• Communicates Deficiencies—Deficiencies are communicated to parties respon-

sible for taking corrective action, and to senior management and the board of

directors, as appropriate.
•• Monitors Corrective Actions—Management tracks whether deficiencies are

remediated on a timely basis.
Approach: Assessing and Reporting Deficiencies

• Assesses Results 483 Management develops policies and practices to periodically assess and communicate
• Communicates Dificiencies deficiencies that result from the entity’s monitoring activities and other sources. Man-
agement establishes a practice where all deficiencies in internal control over external
Monitors Corrective Actions
financial reporting, regardless of materiality, are reported to the responsible manager
and at least one level of management above, both of whom are positioned to take
or oversee corrective action. Management also classifies deficiencies for the further
reporting to senior management or the board based on criteria established by standard
setters or regulators.20 The criteria could include the following:
•• Nature of the deficiency
•• Source of the deficiency
19 In many cases the board of directors will appoint a committee to oversee the system of internal control
depending on the objective. For example the board may appoint an audit committee to oversee system of
internal controls for financial reporting.
20 For example, in the United States, the Securities and Exchange Commission issued “Commission Guid-
ance Regarding Management’s Report on Internal Control Over Financial Reporting Under Section 13(a) or
15(d) of the Securities Exchange Act of 1934” section B. 1. covers the Evaluation of Control Deficiencies
that provides management with guidance on the assessment and reporting of deficiencies.

Monitoring Activities | Evaluates and Communicates Deficiencies
•• Known magnitude of a misstatement caused by the deficiency to the entity’s

financial statements
•• If not known, the likelihood and potential magnitude of misstatement caused by

the deficiency to the entity’s financial statements
•• An aggregation of deficiencies affecting similar areas that could indicate a more

serious deficiency.
Example: Identifying Sources of Deficiencies

484 The senior management of Adelie Telecom receives a quarterly report of deficiencies
prepared by its internal audit department. On the third quarter report this year, deficien-
cies were reported from several sources, including the following:
•• External Source—Customer complaints about overbilling were brought to man-

agement’s attention and investigated. The subsequent investigation exposed
that the billing system was using the wrong tariff rate, which had been incorrectly
coded in the system. The problem was traced to an input error that was neither
prevented nor detected by control activities.

•• Separate Evaluations—Management directed internal audit to conduct a special
evaluation of the sources and quality of information used for Adelie Telecom’s
payroll reconciliation. The evaluation identified that some of the information used
was not appropriate. Specifically, an outdated report with inaccurate information
was being used for the reconciliation. Consequently, the payroll reconciliation
control activity was updated to use the correct report.
•• Ongoing Evaluations—Adelie Telecom allows a 10% variance in paying installa-

tion contractors, and so management developed an automated monitoring control
to review the trends in variance activity approvals by payables clerks. One such
report identified that Arnie Chinstrap, a payables clerk, was routinely approving
variances of 10% for a particular vendor, Bosque & Sons Installers. An investiga-
tion confirmed that Mr. Chinstrap had an arrangement with Bosque & Sons for
a financial kickback and that Adelie Telecom was overpaying the contractor. To
address the deficiency in internal control, management implemented a supervi-
sory review for all payments within the 10% variance.
Example: Reporting Protocols for Identified Deficiencies

485 The management of Skea and Associates, an international insurance services organi-
zation, classifies financial reporting control deficiencies identified from its monitoring
activities as deficiencies, significant deficiencies, or material weaknesses. The com-
munication structure for reporting deficiencies is based on their potential impact on the
organization.
486 For each level of deficiency,21 the company’s internal reporting structure calls for certain
reporting procedures:
•• Deficiencies are reported in detail to the manager responsible for the control.
21 For purposes of this example the deficiency classifications used are those related to external financial
reporting in the US as promulgated by the SEC.

•• Significant deficiencies are reported in detail to the manager responsible for

the control and to the senior management team, and on a quarterly basis, in
summary, to the audit committee.
•• Material weaknesses are reported in detail to the manager responsible for

the control and the senior management team, and on a quarterly basis to the
audit committee.
Approach: Monitoring Corrective Action

Assesses Results 487 Management establishes a practice to review the status of corrective actions taken
Communicates Dificiencies to verify that reported deficiencies are remediated in a timely manner. The corrective
• Monitors Corrective Actions
action practice may include:
•• Regularly scheduled meetings to review the status of corrective actions
•• An established electronic or hard-copy report in which corrective actions are

summarized and collated

•• Delegated oversight to a responsible party, such as an internal audit function
Example: Establishing Reporting Protocols for Identified

Deficiencies
488 The senior management of Lwiski Manufacturing tracks all control deficiencies identi-
fied during monitoring activities and assesses their impact on the organization. These
control deficiencies are reported to the management team responsible for the relevant
business unit. If necessary, the management team works with internal audit to develop
the remediation plan, and internal audit provides oversight to verify deficiencies are
remediated in a timely manner.
489 Specifically, the plan calls for one individual within the business unit to be assigned
responsibility for remediating specific control deficiencies. A time frame for remediation
is assigned to each control deficiency, based on its ranking. Working together, man-
agement and internal audit verify that deficiencies are remediated within the specified
time frame.
Example: Follow-Up Reporting on Internal Audit Issues

490 Mr. James, the chief audit executive of Puna Incorporated, has established a data-
base that tracks management action plans related to issues coming from internal audit
reports. Mr. James receives timely updates on the status of actions from business
process owners, and also periodically reports to the audit committee summaries of the
status of action plans. The reporting includes the percent of action plans implemented
on time by business unit.
491 When sufficient action has not been able to be taken by the business on important
internal audit issues by the original reported implementation date, the process owner for
the area is invited to attend the audit committee and explain the issues associated with
implementation of appropriate actions.

Monitoring Activities | Evaluates and Communicates Deficiencies
Approach: Developing Guidelines for Reporting Deficiencies

492 The board of directors develops a shared expectation with senior management on the Assesses Results
types of control deficiencies that get reported to the board. The board of directors • Communicates Dificiencies
understands the facts and circumstances regarding internal control deficiencies that Monitors Corrective Actions
impact external financial reporting and provides oversight on management’s conclu-
sions and remediation plans.
Example: Reporting Deficiencies to the Board

493 Klemmens and Waters provides air transportation services. The management of the
company periodically develops a report of significant deficiencies and material weak-
nesses, a summary of minor deficiencies, and a summary of past deficiencies. The
purpose is to track whether deficiencies are being remediated in a timely manner. The
reports are presented to the board for review.
494 Management has also developed with the audit committee a shared expectation, which
states that regardless of the previous categorization, management will report all defi-
ciencies resulting from:

•• Illegal or otherwise improper acts
•• A significant loss of assets
•• Intentional errors and omissions in the conduct of external financial reporting
495 The audit committee is briefed on the cause of the reported deficiencies and provides
oversight of management’s assessment of the deficiencies and the actions and status
of remediation plans.


Appendix
Appendix

Examples by Topic
Examples of Changes
This appendix demonstrates examples relating to the changes noted in the Foreword.
1. Expectations for Governance Oversight

Assessing and Disclosing Director Qualifications 25
Assessing the Potential of Management Override 27
Changing the Board Composition of a Closely Held Company 25
Facilitating Communication between

Executive Management and the Board of Directors 119
Maintaining Oversight 67
Draft for Discussion Reviewing and Documenting Key Activities of the Audit Committee 21
Reviewing Financial Statement Estimates 26
2. Globalization of Markets and Operations

Automating Balance Sheet Reconciliations 84
Changes in Business Operations 134
Conducting Senior Financial Officer Visits 139
Reorganizing to Support Control Structure 29
3. Changes and Greater Complixity in the Business

Aligning Roles and Responsibilities with Objectives 31
Establishing Periodic Communications

with Contractors and Outsourced Service Providers 124
Evaluating Business Activities to Identify Information Requirements 106
Implementing or Assessing Control Activities

when a Report on Controls at a Service Organization is Not Available 81
Maintaining Control while Engaging Outside Service Providers 31
Obtaining a Report on Controls at

a Service Organization from a Cloud-Based Service Provider 90

Appendix
Obtaining a Report on Controls

at a Service Organization from a Service Payroll Provider 80
Obtaining Information from External Sources to

Assist with Accounting Estimates 126
Reorganizing to Support Control Structure 29
Responding to Significant Change from an Acquisition 71
Retaining External Tax Assistance 36
4. Demands and Complexities in Laws, Rules, Regulations,

and Standards
Analyzing Risks from External Factors 63
Assessing the Suitability of Specified Objectives 49
Implementing Complex Accounting Standards 35

Obtaining Information from External Sources
to Assist with Accounting Estimates 126
Reviewing and Updating Statutory Reporting Requirements 51
Reviewing and Updating Understanding of Applicable Standards 51
Using Templates to Document Policies 97
5. Expectations for Competencies and Accountabilities

Ad Hoc Assessing of Control Activities 101
Aligning Competencies with Key Financial Reporting Positions 38
Assessing and Disclosing Director Qualifications 25
Assessing Key Financial Reporting Personnel 38
Audit Committee Review of Managers’ Roles 37
Planning for Executive Transition 72
Recruiting and Retaining Key Financial Reporting Positions 35
6. Use of, and Reliance on, Evolving Technologies

Analyzing Risk for Information Technology 61
Analyzing Risks from External Factors 63

Automating Balance Sheet Reconciliations 84
Capturing Information through Electronic Data Interchange 109
Data Capture and Processing for the Purchasing and Payables Cycle 112
Establishing Logical Security 92
Evaluating Business Activities to Identify Information Requirements 106
Evaluating Financial Close End-User Spreadsheet Control Activities 89
Identifying and Classifying Data for Financial Reporting 115
Managing Changes to Custom Software 94
Managing Changes to Packaged Software 93
Obtaining a Report on Controls at

a Service Organization from a Cloud-Based Service Provider 90
Using Automated Tools to Enforce the Segregation of Incompatible Functions 86
Draft for Discussion Using Data Warehouse to Facilitate Access to Information 111
Using Governance, Risk, and Compliance Technology to Manage Internal Controls 118
Using Technology to Identify Trends 138
Validating Data and Information 114
Varying Control Activities in an SDLC Based on Risk 95
7. Expectations Relating to Preventing and Detecting Fraud

Analyzing Fraud Risk by the Internal Audit Department 67
Assessing Fraud Risk 66
Assessing the Potential of Management Override 27
Cascading Responsibilities throughout the Organization and Measuring Results 41
Conducting Ethics Audits 17
Conducting Senior Financial Officer Visits 139
Employee Ethics Hotline 121
Evaluating Misconduct Reported through an Anonymous Hotline 18
Reporting and Investigating Fraud 68
Reporting Deficiencies to the Board 145
Taking Action when Deviations Occur 19

Appendix
Other Examples
Addressing Succession Planning 39
Aligning Incentives with Ethics and Values 43
Analyzing Compensation Structure 68
Analyzing Risk across Functions 54
Assessing Materiality for a Private Company Financial Statement 50
Assessing Risks to Significant Financial Statement Accounts 55
Balancing the Types of Control Activities 82
Changing the Internal Audit Plan 134
Communicating Internal Control Information to Oversee a Federal Agency 124
Communications from Regulatory Bodies 126

Conducting Discussions with Customers 127
Conducting Separate Evaluations 139
Configuring IT to Support the Complete and

Accurate Processing of Transactions and Data 92
Configuring the IT Infrastructure to Support

Restricted Access and Segregation of Duties 91
Considering Changes in Information Systems 64
Considering Risk Response in a Revenue Process 64
Considering the Range of Assessment Activities 52
Controlling Significant Accounting Estimates 83
Defining and Communicating a Code of Business Conduct and Ethical Standards 15
Defining and Communicating the Basis for Reward 42
Defining Performance Expectations 35
Deploying Control Activities through a Central Control Function 100
Developing Alternate Candidates for Key Financial Reporting Roles 39
Establishing a Baseline 135
Establishing a Cross-Functional Internal Control Committee 122
Establishing a Mentoring Program to Encourage Communicating with Management 121
Establishing an Audit Committee Meeting Calendar 22

Establishing and Overseeing Performance Measures, Incentives, and Rewards 43
Establishing Policies and Procedures 98
Establishing Reporting Protocols for Identified Deficiencies 144
Evaluating Preventive versus Detective Control Activities 82
Facilitating Communication with External Parties 128
Follow-Up Reporting on Internal Audit Issues 144
Gathering Information from External Sources 108
Identifying and Protecting Financial Data and Information 115
Identifying and Responding to Risk 61
Identifying Sources of Deficiencies 143
Interacting with Auditors 27

Linking Accounts, Assertions, and Risks 47
Maintaining Data Flow Diagrams, Flowcharts, Narratives, and Procedures Manuals 107
Managing and Assessing External Audit Communications 129
Obtaining Operating Information for Financial Reporting 110
Performing Control Activities in a Timely Manner 100
Periodically Assessing Performance 37
Periodically Reviewing Policies 34
Preparing Effectively for Meetings 24
Preparing Financial and Internal Control

Reporting Package for Discussion with the Board 120
Preparing for a Change in CEO 72
Providing Recognition for Suggestions Made to Enhance Internal Control 44
Reacting to Significant Change Caused by External Factors 70
Redefining Roles with CEO and Board Input 30
Regularly Assessing Policies and Procedures 101
Reporting Protocols for Identified Deficiencies 143
Responding to Significant Change from International Exposure 71
Reviewing and Updating Understanding of Applicable Standards 51

Appendix
Reviewing Cost Overruns 99
Reviewing Financial Accounting Policies 51
Reviewing the Service Auditor’s Report for Changes in Controls 141
Setting the Threshold for Business Performance Reviews 83
Specifying Objectives 48
Taking Corrective Action 100
Updating Risk Assessment for a New CEO 70
Using a Company Newsletter to Reinforce Expectations of Integrity and Ethics 16
Using Alternative Control Activities when

Access to Purchasing Transactions Are Not Segregated 85
Using a Matrix to Map Risks to Control Activities 77
Using an Internal Accounting and Finance Conference to Reinforce Policy Changes 117

Using an Inventory of Risks and Control Activities 79
Using a Walkthrough to Understand Technology Dependencies 88
Using Benchmark Data to Assess Significance and Response to Risk 62
Using Built-In Operating Measures and Key Control Indicators 137
Using Communications Programs to Reinforce Internal Control 117
Using Continuous Monitoring 138
Using Dashboards to Relate Operating Information 138
Using Metrics to Monitor Payroll 136
Using Risk Ratings 60
Using Self-Assessments 139
Using Workshops to Map Identified Risks to Control Activities 76

November 16, 2012.
responses by fax.

COSO - Internal Control Over External Financial Reporting

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COSO - Internal Control Over External Financial Reporting

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Co m m it te e o f S p o n s o r in g O rgani z ati o ns o f the Tre adway Co mmi ssi o n

Inter n al Co n t ro l — I n te g rate d F ra mewo rk

Draft for Discussion

Internal Control over External Financial Reporting:

Draft for Discussion

Co m m it te e o f S p o n s o r in g O rgani z ati o ns o f the Tre adway Co mmi ssi o n

Board Members Representative

COSO Chair David L. Landsittel

American Accounting Association Mark S. Beasley

The Institute of Internal Auditors Richard F. Chambers

American Institute of Certified Public Accountants Charles E. Landes

Financial Executives International Marie N. Hollein

Institute of Management Accountants Sandra Rictermeyer

Draft for Discussion

Miles E.A. Everson Engagement Leader New York, USA

Stephen E. Soske Project Lead Partner Boston, USA

J. Aaron Garcia Project Lead Director San Diego, USA

Cara M. Beston Partner San Jose, USA

Charles E. Harris Partner Florham Park, USA

Eric M. Bloesch Managing Director Philadelphia, USA

James M. Downs Director San Francisco, USA

Frank J. Martens Director Vancouver, Canada

Jay A. Posklensky Director Florham Park, USA

Charles J. Finn Senior Manager Detroit, USA

Natalie Protze Senior Manager Washington D.C., USA

Sponsoring Organizations Representatives

Audrey A. Gramling Bellarmine University Fr. Raymond J. Treece

Draft for Discussion

Regulatory Observers and Other Observers

James Dalkin Government Accountability Director in the Financial

Mark Cohen Partner San Francisco, USA

Andrew Dahle Partner Chicago, USA

Junya Hakoda Partner (Retired) Tokyo, Japan

Brian Kinman Partner St. Louis, USA

Pat McNamee Partner Florham Park, USA

Jonathan Mullins Partner (Retired) Dallas, USA

Alexander Young Partner Toronto, Canada

Antoine Elachkar Managing Director Washington D.C., USA

Gary Moss Managing Director Milwaukee, USA

Catherine Jourdan Director Paris, France

Draft for Discussion

Christopher Michaelson Director Minneapolis, USA

Sallie Jo Perraglia Manager New York, USA

Tracy Walker Director Bangkok, Thailand

Qiao Pan Senior Associate New York, USA

•• American Accounting Association (AAA)

•• American Institute of Certified Public Accountants (AICPA)

•• Financial Executives International (FEI)

•• Institute of Management Accountants (IMA)

•• The Institute of Internal Auditors (IIA)

Draft for Discussion

5. Information and Communication...........................................................103

Examples by Topic ......................................................................................148

Internal Control — Integrated Framework • September 2012

Draft for Discussion

•• Expectations for Governance Oversight—Higher regulatory and stakeholder

•• Globalization of Markets and Operations—Organizations expand beyond domes-

•• Changes and Greater Complexity in the Business—Organizations change busi-

Internal Control — Integrated Framework • September 2012 i

•• Demands and Complexities in Laws, Rules, Regulations, and Standards—Regula-

•• Expectations for Competencies and Accountabilities—Demands for greater

Draft for Discussion

4 Each of these changes requires an organization to evaluate the implications on its